A Dozen Lessons on Building a Business from Sarah Tavel

 

  1. “Ultimately when evaluating an early stage company, I say it’s a combination of art and science. The art is understanding how products work, the science is knowing how to measure it. The earlier the company, the more it is about art, which in this case is assessing what I think of the product and the use case.” 

Tavel is a great fit for Benchmark since the firm has always believed what they do is a craft. I wrote about this in my blog posts on Andy Rachleff, Peter Fenton and Bill Gurley. Fenton has said:

“because we love the day-to-day work with the entrepreneurs, [it] prevents us from scaling. We don’t have an ability to offload any part of our relationship in the way we practice it, to anyone other than ourselves. So, there’s no associates, no principals, there is really nothing beyond the group of people here and our assistants who keep our lives sane. That’s a strategy.”

What Benchmark partners like to do is invest early and work shoulder-to-shoulder with entrepreneurs. The Benchmark partners would use that approach even if it was not the best way to optimize their financial return since it is what they enjoy most about the process. The “art” of venture capital Tavel is referring to is often found in pattern recognition and that is highly related to good judgment which often comes from first party bad judgment or what Will Rogers once called watching other people pee on an electric fence (third party band judgement). It is important to note that a critically important part of the pattern recognition in venture capital is finding the exception to previous patterns that is different. Part of the pattern is: some rule that other people preciously believed was important is being broken by the best startups, but some rules that other people thought were important are being followed. It is a bit like the spot the difference game, except it must be a very important difference that delivers significant new core value to a really big market.

I have written about the science part of the entrepreneurial process quite a bit lately. Generating growth in a startup is accelerated by great data science because it allows you to measure results and apply the scientific method to growth experiments. When founders get access to great data science they have a greater ability to scale their output and most importantly make their creative contribution enduring. Data science does not eliminate the need for creative sparks, but when used effectively it facilitates creativity by enabling rigorous experimentation and increases the impact and growth of the business.    

  1. “For seed investments, it’s always first team, and second, believing in what they’re doing (as early as it is). I’ve passed on opportunities that had amazing teams, but I just couldn’t get behind what they were doing, for whatever reason. It doesn’t feel authentic to me to just make an investment on #1, if I’ll spend our conversations together trying to convince them that they should change #2. So really both need to line up for me.”

One of the reasons I write about so many different venture capitalists is to make the point by example that there is no cookie cutter way to be successful investing in startups. There are many similarities and common elements, but many differences too. My view is that there are different pools of alpha and different people search for that alpha in different ways. Of course, some investors are more successful than others. Typically the investors that are most successful chose an approach that is most consistent with their nature and unique skills. Benchmark co-founder Bruce Dunlevie puts the strength of the team at the top of the early stage investing hierarchy. Another Benchmark co-founder Andy Rachleff puts more emphasis on the existence of a very large addressable market. Of course, this is a matter of emphasis as both the right team and the right market are important. That Benchmark has adopted a craft rather than a platform approach to their business does not mean that other approaches by other venture capitalists do not work. It is just the right approach for them as individuals and gives then a unique service to offer founders.  Some founders will be more comfortable with a full service venture capital platforms. Some will not. Vive la différence. Strategy is what you do differently than your competitors. You must be different and you must be right about that difference if the strategy is going to be successful. 

  1. “Spend money very very carefully until you have product market fit. You want as lean a team as possible before you get there. There is no point of hiring more than the bare minimum team (usually just the co-founders) before you figure out what users want. Then you scale. Companies that hire before that waste runway, and that’s a shame. Once you have product market fit, you still need to be careful with hiring. 

The critical point Tavel is making is that it make no sense to pursue a growth hypothesis before the company has solved the value hypothesis. Why would you try to get more people to use a product that does not have core product value? It is not only hard to create core product value but the discovery process (if it happens) inevitably requires time and experimentation. The shorter the financial runway of the business the less opportunity exists for the startup to discover product market fit and solidify its value hypothesis. Tavel also notes that hiring is something to be approached with care even after the value hypothesis is proven. Early hires are particularly important as they create the business’ DNA place much more than later hires. Company culture is far more a determinant of success than people imagine. 

  1. “Another thing I see is scaling too quickly, particularly for local businesses. I see a lot a company launch something in one city, and before they’ve figured out the playbook, launch a bunch of other cities which burns through their cash, without really figuring out how to make it work in any one city.” 

Benchmark’s Bill Gurley has said: “We like to say that ‘more startups die of indigestion than starvation.’” One cause of death by indigestion is premature scaling of a growth hypothesis that has not been proven. Putting fuel in a rocket which does not have an attractive target and a working guidance system is a bad idea. Even if there is product market fit, there is a right time to spending big on generating growth and that time if after a sound growth hypothesis has been proven. 

  1. “I’d say that companies that have the greatest chances of becoming sustainable unicorns have incredibly strong network effects or economies of scale. More often than not, you find this with platforms/marketplaces, but not always. e.g., companies like Amazon or big banks, have very strong economies of scale, that make it very difficult to compete. But they take an enormous amount of capital to build.” 

Tavel is pointing out that the primary means of defending a business against competitors today is network effects. My blog post on network effects is here. Other approaches that can create a barrier to entry like economies of scale, regulatory expertise, intellectual property and brand still matter, but they are relatively less important than they once were, especially in the case of software startups. Economies of scale are desirable and complement network effects in many cases, but Tavel is pointing out that they are not “capital light.” One of the big changes in the business world that Charlie Munger and Warren Buffett talked about at the recent Berkshire meeting was the appearance of technology businesses that do not require much capital.

  1. Growing users without growing users completing the core action is the empty calories of growth. It feels good, but it’s not good for you. What is a core action? The action that is the very foundation and essence of your product. Pinterest would not exist without pinning. Twitter would not exist without tweeting.” 

There are a number of terms used to describe the factors that can create sustainable growth. One term that I like is the concept core product value, which represents a solution a real and significant problem that is valuable enough to cause people to want to pay for a product. Core product value is first recognized when the customer connects with the product in what is known as a “magic moment.” A magic moment is a realization or reaffirmation by a customer that a product has core product value. Tavel is saying that that a “core action” is what the customer does to realize core value.

There are different types of magic moments. My taxonomy is as follows:

  1. Hook magic moment – a realization of core product value that occurs within the first 15 seconds of customer on boarding that creates retention. There should be as little friction as possible in getting the visitor to the Hook magic moment as fast as possible.  Delivering the core experience quickly without overwhelming the visitor with features and sign up requirements is critical. For example, Alex Schultz of Facebook explains:

“[if you want] people to buy an item on eBay, should I land them on the registration page or the search results page?” You’d probably land them on the search results page, and that would get them to that magic moment faster. What is the moment when you used AirBnB? What  is the moment when you used DoorDash, when you used Slack, when you used Facebook,  LinkedIn, WhatsApp? Whatever the product, what is that moment when you went, ‘Yes. I’ve got  it.’ On Facebook it’s friends. Getting  that first person reserve your house, staying at that first property, those are our magic  moments. eBay, buying your first item from a stranger online.”

Scott Belsky describes the objective:

“Just one example: At Behance, in the sign-up process for our service, we used to ask new Behance members to select their top three creative fields. New users took an average of 120 seconds to browse the list and select their top fields. We lost around 10% of new members at this particular step in the sign-up process. And so, we removed it from the sign-up process and resolved ourselves to capture this information later on during active use of the website. As a result, sign-ups went up. This is true for every online service or store. In the first 15 seconds, your visitors are lazy in the sense that they have no extra time to invest in something they don’t know. They are vain in that they want to look good quickly using your product. And they’re selfish in that, despite the big picture potential and purpose of what your service.”

  1. Critical mass magic moment–  a realization of core product value that is strong enough to ensure that customers are retained over the long term. To determine whether retention has reached a critical mass. A Bain study concluded:

“Depending on which study you believe, and what industry you’re in, acquiring a new customer is anywhere from five to 25 times more expensive than retaining an existing one. It makes sense: you don’t have to spend time and resources going out and finding a new client — you just have to keep the one you have happy. If you’re not convinced that retaining customers is so valuable, consider research done by Frederick Reichheld of Bain & Company (the inventor of the net promoter score) that shows increasing customer retention rates by 5% increases profits by 25% to 95%.”

  1. Reinforcing magic moments–  customers experiencing “core product value” reinforcement while experiencing the product. An example of this approach happens when Facebook sends you a message that someone has tagged you in a photo. The intent is to harness your curiosity to drive you back to core product value. For Facebook, reinforcing magic moments include adding a friend, liking or sharing a post, or updating your status within 24 hours of downloading the mobile app. Chamath Palihapitiya believes you can create loops that expose that core product value over and over again. he says:  “You have to work backwards from ‘what is the thing that people are here to do?’ ‘What is the A-ha moment that they want?” Schultz cautions:There’s a really fine line between removing friction and duping users. Tricking users hurts users. Adding friction hurts users.”
  2. Reactivation magic moments–  experiences that cause a customer to returns to a service after being inactive. “We missed you” emails are intended to trigger this type of Magic Moment.

How do you discover magic moments for your service? The objective is to look for correlations between usage, demographics and other behavior and retention. Examples of magic moments discovered by some businesses include adding seven friends in ten days or sending several thousand messages.

  1. “Virtuous loops are the flywheels that covert your users’ engagement into fuel to power your company forward. The strongest virtual loop is a network effect. Virtuous loops are really hard to create. Most products don’t have them.”

Virtuous circles and vicious circles are processes which can reinforce themselves through a feedback loop. Virtuous circles produce feedback that results in an increasingly positive outcome and vicious circles the inverse of that. One famous picture of a flywheel at work that you see a lot is this one below which describes one aspect of Amazon’s business:

AMZN loop

  1. “To get the flywheel spinning for a marketplace, you can’t sit in front of your computer and code. You need to pound the pavement more often than not and do things ‘that don’t scale’ to get the liquidity to help you start scaling.” 

Y Combinator co-founder Paul Graham describes what a business must do to start a business from a standing start better that just about anyone I have seen: 

The most common unscalable thing founders have to do at the start is to recruit users manually. Nearly all startups have to. You can’t wait for users to come to you. You have to go out and get them. A good metaphor would be the cranks that car engines had before they got electric starters. Once the engine was going, it would keep going, but there was a separate and laborious process to get it going.”

There is a big difference between doing things that don’t scale and being in a business that won’t eventually scale. Scalability is an important goal for any business but almost always in the beginning efforts  will be require that don’t scale well.  CEOs will go on sales calls, products will be created by hand, and many manual processes will be used at first. This info-graphic captures some non-scalable approaches that startups have used to bootstrap their flywheels past the cold stat problem.

scale

http://fundersandfounders.com/do-things-that-dont-scale-in-startups/

  1. In non-transactional products, real value will be created when you create accruing benefits.  A product has accruing benefits if a user would say the more I use the product, the better it gets.’” 

Tavel uses examples from her experience at Pinterest to make this point:

accrue

10. “Mounting loss happens as a product becomes something you depend on, part of your identity, or a product in which you’ve accrued value of some sort (e.g., a following). ‘I’d have a lot to lose if I left this product’ is the claim to test.”

mount

11. “The clearest way to understand a company’s engagement is to look at cohorts: number of weekly users completing the core action and percentage of weekly active users completing the action.”

There are an endless number of ways you can think about cohorts. One simple approach to illustrate what can be done is to look at a cohort’s behavior graphically: the number of days from acquisition is on the x axis, on the y axis is the percent of people who are still monthly active. With each day that passes some members of the cohort will stop using the service but the critical mass objective is to get the curve to “flat line” in a way that asymptotes with the x axis. What causes the line to stop dropping is often the network effects of more people being on the network creating a critical mass of value for the customer.

A retention curve that does not flatten and instead drops to zero may be caused by a product market fit problem or it may be the nature of the product (e.g. some video games). The single most important factor that drives growth is retention.

 retain

12. “Blogging is venture capital’s freemium model.”

There are at least three reasons that venture capitalist’s write for public consumption.

  1. It helps the writer think things through and find new solutions and ways to communicate ideas.
  2. It is way to give back- teaching is a way of giving back.
  3. It is way to use content marketing to source new deal flow.

It’s always nice when you get three things for the same amount of effort. It is even better if you can do well financially by doing something good for other people. Regardless of whether someone is first starting out or even if they are a big success writing is a way to turn thinking, words and effort into a substitute for capital. Content marketing is both more capital efficient and produces better results than traditional marketing. 

Writing is my way of giving back. Revenue is negative. It makes me feel good though, which is highly underrated.

Notes: 

The Hierarchy of Engagement, expanded https://medium.com/@sarahtavel/the-hierarchy-of-engagement-expanded-648329d60804

How To Create A Sticky Product Like Facebook and Evernote https://www.linkedin.com/pulse/accruing-benefits-mounting-loss-sarah-tavel 

How to build an enduring, multi-billion dollar business https://medium.com/@sarahtavel/how-to-build-an-enduring-multi-billion-dollar-business-hint-create-a-10x-product-recast-3527df2b8fcb 

Engagement Hierarchy: Core Actions  https://medium.com/@sarahtavel/engagement-hierarchy-core-actions-dd4f72042100 

Venture Capital’s Freemium Model http://www.adventurista.com/2009_11_01_archive.html 

Growth Hackers AMA https://growthhackers.com/amas/live-jun-14-ama-with-sarah-tavel-vc-at-greylock-partners

Lesson from Scaling Pinterest https://medium.com/@sarahtavel/five-more-lessons-from-scaling-pinterest-9c10fe97d325

The Mitochondria of Startups https://www.linkedin.com/pulse/mitochondria-startups-sarah-tavel

20 Minute VC https://www.producthunt.com/posts/the-twenty-minute-vc-sarah-tavel-partner-greylock-partners

Graham- Do Things that Don’t Scale http://paulgraham.com/ds.html

Bain:  https://hbr.org/2014/10/the-value-of-keeping-the-right-customers

Belsky: https://medium.com/positiveslope/the-first-15-seconds-9590d7dabc

Alex Schultz: https://venturebeat.com/2014/08/06/facebook-growth-chief-you-lose-users-if-you-try-to-trick-them/

Quora:  https://www.quora.com/Growth-Hacking/Growth-Hacking-How-do-you-find-insights-like-Facebooks-7-friends-in-10-days-to-grow-your-product-faster-1?utm_content=buffer2afcc&utm_medium=social&utm_source=twitter.com&utm_campaign=buffer#!n=12

A Dozen Lessons about Money and Investing from Kendrick Lamar (K-Dot)

 

  1. “What I’ve learned is the best thing I can do with the position I’m in, and the places I’ve gone, is sharing this same information and giving you a step by step guide on the do’s and don’ts of what I’ve gained from talking to Jay Z and these different moguls in the business — whether talking about business, or just life. I can’t keep all of the information to myself, I have to share it. Within doing that, it’s giving me just as much as it’s giving them, and that’s worth more than any dollar amount.” Forbes Interview.

K-Dot is making the same point Charlie Munger was trying to convey when he said: “The best thing one human being can do for another human being is to help them know more.” Trying to figure out everything in life by yourself from first principles not only does not scale well, but it involves lots of unnecessary pain. Life gets easier when you learn vicariously from the mistakes of other people. You can do this by watching other people’s behavior or by reading about it. Munger advises: “I believe in the discipline of mastering the best that other people have figured out. I don’t believe in just sitting down and trying to dream it all up yourself. Nobody’s that smart.” K-Dot is also saying that an approach to life that includes teaching other people inevitably means you get back more than you give (e.g., the process of teaching anything makes you learn the topic even better). The other factor involved is what Munger has referred to as “penance.” Mohammad Ali  made a similar point once when he said: “Service to others is the rent you pay for your room here on earth.” Giving back to other people is not just beneficial because you learn more, it is by itself a moral imperative. 

  1. “If you get your first big check and you cop a chain before you buy a house. You’re a vanity slave.” Vanity Slave.

K-Dot is cautioning people to stay grounded about priorities, especially when fortune suddenly arrives. Vanity, greed and ego can cause people to make bad choices. He makes his point with an example: copping a chain before you take care of other basic needs is vanity. Concern about the adverse impact of vanity is not a new idea. For example, Jane Austen wrote: “Vanity and pride are different things, though the words are often used synonymously. A person may be proud without being vain. Pride relates more to our opinion of ourselves, vanity to what we would have others think of us.” I would rather put a viper down my shirt than let someone else determine whether I am happy. Getting control of your desire for ever more stuff is mentally healthy. Seneca once said: “It is not the man who has little, but he who desires more, that is poor.” In contrast, being ever covetous despite gains in wealth only increases the probability that you will be miserable. Can you be wealthy and enjoy that but not tie your happiness to maintaining that wealth? Seneca believed: “For many men, the acquisition of wealth does not end their troubles, it only changes them and that “Wealth is the slave of a wise man. The master of a fool.” The best thing you can acquire with money is independence. Munger puts it this way:  “Like Warren, I has a considerable passion to get rich, not because I wanted Ferarris.  I wanted the independence. I desperately wanted it.”

  1. “A dependable savings and you’ll retire with money in your account.” The Lonely Island.

People involved in the entertainment and sports industries often have incomes that are front loaded in the early years of their career. Yes, they can work at another job later in life, but that work may not pay nearly as much as they earned in their prime years. K-Dot is saying that adopting an approach which paces consumption over a person’s entire life is wise. The best way to increase your wealth is to save more of your income. Morgan Housel puts it this way:

“Building wealth has little to do with your income or investment returns, and lots to do with your savings rate. Fortunes can be blown as fast as they’re earned – and often are – while others with modest incomes can build up a fortune over time. Wealth is just the accumulated leftovers after you spend what you take in. And since you can build wealth without a high income but have no chance without a high savings rate, it’s clear which one matters more.”

K-Dot is saying that people should think more about their retirement savings in particular. As just one example of what can happen if you do not save,  among senior beneficiaries in the US, the median Social Security benefit is $14,400. Trying to live on just that income given health care and other expenses is a terrible idea if you can avoid it. Here is some data on that point:

 soc sec

  1. “Take no chances, stop freelancin’; Invest in your future, don’t dilute your finances.” The Lonely Island.

While saving money is the most important step one can take to increase wealth and security, K-Dot is saying that investing is important too. The statistics on where many people stand on people’s financial preparation for retirement are dire. For example, “~1/2 of families have no retirement account savings at all. Median values are low for all age groups.” http://www.epi.org/publication/retirement-in-america/#5 …

sav

  1.  “401K, make sure it’s low risk.” The Lonely Island. “At 27, my biggest fear was losin’ it all.” Fear.

K-Dot is talking about the need for investors to control risk, especially when it comes to retirement funds in something like a 401K. Before a person can control risk it is necessary to define it. I particularly like the definition of risk adopted by Howard Marks: “In thinking about risk, we want to identify the thing that investors worry about and thus demand compensation for bearing. I don’t think most investors fear volatility. In fact, I’ve never heard anyone say, ‘The prospective return isn’t high enough to warrant bearing all that volatility.’ What they fear is the possibility of permanent loss.” Warren Buffett recently told a story about someone worrying about having enough money in their retirement that is both relevant and amusing:

“I had an Aunt Katie here in Omaha… She worked really hard all her life, lived in a house she paid $8,000 for… Because she was in Berkshire she ended up — she lived to 97 — she ended up with a few hundred million and she would write me a letter every four, five months and she said, ‘Dear Warren, I hate to bother you, but am I going to run out of money?’ And I would write her back and I’d say, ‘Dear Katie, It’s a good question because if you live 986 years, you’re going to run out of money. And then about four or five months later, she would write me the same letter again. There’s no way in the world if you’ve got plenty of money that it should become a minus in your life.”

  1.   “Got real estate over there and hustle over here.” Enjoy.

K-Dot is saying that he will not lose focus on the hustle aspects of his life just because he has made real estate or other investments. Nothing generates wealth more reliably that a strong work ethic, a regular income combined with talent and a willingness to save and invest.  My view on actively investing real estate is heavily influenced by the advice my grandfather (a real estate developer) gave to my father the doctor. He said that my dad should leave active real estate investing to professionals. If my father desired exposure to real estate my grandfather suggested that he do so via a fund. He said that it was possible for my dad to become an expert active real estate investor but only if he treated it as a second career, found an area to specialize in and was passionate about it.  Here’s Munger on real estate:

“The trouble with real estate is that everybody else understands it.  And the people who you are dealing with and competing with, they’ve specialized in a little twelve blocks or a little industry.  They know more about the industry than you do.  So you’ve got a lot of bull-shitters and liars and brokers.  So it’s not a bit easy.  It’s not a bit easy.  You don’t even see the good offerings in real estate.  It’s not an easy game to play from a beginner’s point of view.  Real estate.  Whereas with stocks, you’re equal with everybody.  If you’re smart.  In real estate, you don’t even see the opportunities when you’re a young person starting out.  They go to others.  The stock market’s always open.  It’s (like) venture capital.  Sequoia sees the good stuff.  You can open an office, “Joe Schmoe Venture Capitalists: Start-ups come to me!”  You’d starve to death.  You got to figure out what your competitive position is in what you’re choosing.  Real estate has a lot of difficulties.}

  1. “When you’re in this situation with all the lights on you, you’re going to get a lot of offers thrown at you, but if it’s not something that you see has longevity in it, you have to pass it up.” 

K-Dot knows that there are no called strikes in investing. Patience is essential as is waiting for the right offer. Opportunity cost is a huge filter in life. Charlie Munger looks at his investing decisions in this way: “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs. Warren is scanning the world trying to get his opportunity cost as high as he can so that his individual decisions are better.”

  1. “On the business end, it just shows me: always be critical and smart about the moves you make.”

K-Dot is pointing out that it is important to think critically about your decisions since we all have a range of dysfunctional biases that can tend to result in unwise decisions. Everyone makes mistakes. Thinking hard about how you might have made a mistake due to an emotional or dysfunctional factor can pay big dividends. People who can put aside their ego-based defenses and embrace a great idea that someone else discovered tend to get better results in life. “Not invented here” too often means “no benefits here.” Charlie Munger said exactly that the 2017 Berkshire shareholders meeting: “You have to have a habit of reexamining your old ideas from time to time since without that, you can’t see it when they become wrong. A year in which you do not change your mind about something important is a wasted year in his view.

  1. “So just to get a dollar, will I sell my soul? I look the Devil in the eye and tell him, hell no.” Compton State of Mind.

In the end you can make more money from behavior that meets a high ethical standard. Not only it is the right thing to do morally, it is the right thing to do from a profit standpoint. Charlie Munger has said: We don’t claim to have perfect morals, but at least we have a huge area of things that, while legal, are beneath us. We won’t do them.  Currently, there’s a culture in America that says that anything that won’t send you to prison is OK.” What can be more satisfying than doing well financially while at the same time making a positive contribution to society in a way that is highly ethical? Munger tells a story about how he made a fantastic investment by wading into an area where the other people involved are ethically challenged:

“I soon realized that under the peculiar rules of an idiot civilization, the only people who were going to bid for these oil royalties were oil royalty brokers who were a scroungy, dishonorable, cheap bunch of bastards. I realized that none of them would ever bid a fair price.”

  1. “All money ain’t good money.”

K-Dot is channeling a point Dorothy Parker famously made when she said: “If you want to know what God thinks of money, just look at the people he gave it to.” It is that simple.  Munger puts it this way:

“Ben Franklin said: ‘I’m not moral because it’s the right thing to do – but because it’s the best policy.’” “We  knew early how advantageous it would be to get a reputation for doing the right thing and it’s worked out well for us. My friend Peter Kaufman, said ‘if the rascals really knew how well honor worked they would come to it.’ People make contracts with Berkshire all the time because they trust us to behave well where we have the power and they don’t. There is an old expression on this subject, which is really an expression on moral theory: ‘How nice it is to have a tyrant’s strength and how wrong it is to use it like a tyrant.’ It’s such a simple idea, but it’s a correct idea.” “You’ll make more money in the end with good ethics than bad. Even though there are some people who do very well, like Marc Rich–who plainly has never had any decent ethics, or seldom anyway. But in the end, Warren Buffett has done better than Marc Rich–in money–not just in reputation.”

  1. “The best thing I’ve learned is that it’s not about getting a certain amount of dollars and spreading it all out. That process is meant to crumble. That process is meant to bring envy and hate, because once you stop spreading it, or once you stop getting it, you realize there’s just a lot of evil behind it.”

No matter how rich someone like K-Dot may become there are limits to what can be given away. Problems are inevitably created when too much money is given away to a friend or a posse of friends. K-Dot is saying that people who were on the receiving end of gifts have a tendency to get angry if you stop since they feel they have lost something. These angry feelings are heightened due to loss aversion.  Being generous works better when you make sure that the beneficiary is not acquiring an expectation that the gifts will be ongoing. Being generous of charitably minded is not always simple. This is K-Dot in “How Much a Dollar Cost” from the album “To Pimp a Butterfly”:

“…Walked out the gas station
A homeless man with a silly tan complexion
Asked me for ten grand
Stressin’ about dry land
Deep water, powder blue skies that crack open
A piece of crack that he wanted, I knew he was smokin’
He begged and pleaded
Asked me to feed him twice, I didn’t believe it
Told him, “Beat it”
Contributin’ money just for his pipe, I couldn’t see it
He said, “My son, temptation is one thing that I’ve defeated
Listen to me, I want a single bill from you
Nothin’ less, nothin’ more
I told him I ain’t have it and closed my door
Tell me how much a dollar cost

It’s more to feed your mind
Water, sun and love, the one you love
All you need, the air you breathe

He’s starin’ at me in disbelief
My temper is buildin’, he’s starin’ at me, I grab my key
He’s starin’ at me, I started the car and tried to leave
And somethin’ told me to keep it in park until I could see
A reason why he was mad at a stranger like I was supposed to save him…”

  1. “It’s one thing we’ll keep coming back to — remove the ego. I promise you, that’s the most valuable thing I’ve learned.”

Morgan Housel puts it this way:one of the most powerful ways to increase your savings isn’t to raise your income, but your humility.” Morgan knows that ego can easily get in the way of making sound decisions. As I noted in my recent blog post on Ray Dalio, he believes: People are so attached to being right, and yet the tragedy is it could be so easy to find out how you’re wrong.” If you can learn to take ego out of your decision making  you will make fewer mistakes. Buying things and making investments that stroke your ego is short sighted. People who learn to save and invest have better choices in life. Few things are worse in life than having no choices. Munger with a closing thought:

“Then there’s the chasing of the investment return rabbit. What if you had an investment that you were confident would return 12% per annum. A lot of you wouldn’t like that — especially if you’ve done better– but many would say, ‘I don’t care if someone else makes money faster.’ The idea of caring that someone is making money faster is one of the deadly sins. Envy is a really stupid sin because it’s the only one you could never possibly have any fun at. There’s a lot of pain and no fun. Why would you want to get on that trolley?”

Notes:

https://www.forbes.com/sites/julianmitchell/2016/12/13/kendrick-lamar-opens-up-about-growth-success-and-staying-true-to-your-mission/#136027f52525

http://ohhla.com/anonymous/kenlamar/lamar_ep/vanity.ken.txt

https://www.linkedin.com/pulse/kendrick-lamar-talks-growth-success-staying-true-mission-mitchell

https://genius.com/The-lonely-island-yolo-lyrics

https://genius.com/9th-wonder-enjoy-lyrics

https://www.linkedin.com/pulse/kendrick-lamar-talks-growth-success-staying-true-mission-mitchell

https://genius.com/Big-sean-control-lyrics

https://genius.com/Kendrick-lamar-fear-lyrics

https://www.directlyrics.com/kendrick-lamar-control-lyrics.html

Morgan Housel:  http://www.collaborativefund.com/blog/let-me-convince-you-to-save-money/

Nassim Taleb: http://www.econtalk.org/archives/2012/01/taleb_on_antifr.html

The Dot-Com Boom and Bust

 

“Most of the entrepreneurs today weren’t around in ’99. They have no muscle memory of it whatsoever.” Bill Gurley (September 2016)

Unlike the entrepreneurs Bill Gurley is talking about, I have a lot of muscle memory that resulted from the Internet bubble. There is no way you can fully convey in words the experience being in the lead car as an investor in that roller coaster. Looking at the cycle after the fact is nothing like looking ahead and not knowing what will happen next. The experience still impacts the way I think and act. It was a heck of a lot of fun in some ways. If you can’t learn from an experience like we had in the markets during roller-coaster ride that was the Dot-Com phenomenon, you were not paying attention. Good judgment comes from experience and often that experience comes from bad judgment. Most of the bad judgment associated with the Dot-Com era was observed but some of it was mistakes I made all by myself or as part of a herd. It is hard to describe how strong the feeling of FOMO was at the time. People were terrified of missing out on the upside and loss aversion and paper gains made them reluctant to act to cushion the downside.

Every story must have a starting point. The best time to begin this tale is probably 1993 when the business environment first started to change in way that would develop into a bubble. Changes that we would look back at later and say “that was crazy” did not happen in a huge way at first. The initial buildup was gradual and steady at the outset. But by 1994 the parties started getting better, the tchotchkes more lavish and paper wealth created at an impressive pace. Everyone was a frog in a pot of boiling water but they mostly did not feel it. By 1995 having in the Rolling Stones or The Eagles play at a private party hosted by a bigwig was becoming normalized in some circles in certain geographies.

One aspect of the abnormality of the period was the rapid jump in the number of IPOs. This chart shows the “IPO pig coming through the snake” in the mid to late 1990s. It also puts the current IPO market into perspective.

Not Many IPOs

Venture backed IPOs looked like this chart below. One VC quoted on Bloomberg recently predicted 30-35 IPOs in 2017. As a benchmark for comparison, there were 21 tech IPOs in 2016, 23 in 15 and 55 in 2014 and 84 in 2013.

vbacked

The amount of paper wealth that was being created did not start to accelerate to bonkers levels until ~1996. While 1996 had the most IPOs 1999 was the pivotal year in terms of the valuations and amounts of money raised:

money raised

One aspect of the IPO craziness of the Dot-Com era was the first day pop. Getting an allocation of “friends and family” shares for an IPO seemed to some people like a guaranteed way to make a profit in 1999. Like most bubble phenomenon that first day pop approach worked until it suddenly didn’t.

While the madness was going on there were people who predicted that a bubble was forming and that it would end badly; some of these people took their fund to $0 by shorting stocks too early. That experience illustrated how being early in making a prediction is indistinguishable from being wrong. By late 1999 I remember thinking “everyone can’t really be this rich. Or can they?” Some people became fabulously rich on paper in just months and the impact of that was that envy and jealousy which caused other people to lose their tie to reality. The environment was literally nuts. FOMO made people do things that in retrospect seem insane, but at the time seemed reasonable. Here’s a recap:

“Initial public offerings raised more than $69 billion in 1999, 39 percent more than 1996, the second-biggest year, according to Thomson Financial Securities Data. More eye-popping, however, may be the year’s record first-day gains. VA Linux jumped a record 733 percent in its first day of trading in early December. One hundred and seventeen, or 23 percent, of the year’s IPOs soared more than 100 percent in the first day of trading, according to WorldFinanceNet.com. The average first-day gains of 68 percent this year trounced last year’s average rise of 23 percent. The year registered nine of the top 10 first-day IPO gains of all-time, according to IPO.com.”

VAlin

What happened to VA Linux?

changed it

Geeknet now sells classic items like:

tiki

A Salon article in April of 2000 article painted a picture of the party scene in the technology world that was produced by too much cash chasing too little value. What is most notable perhaps about the article is that it appeared after the bubble had popped. The party scene was operating on momentum still, but about to come to a calamitous halt.

“Jessica Crolick downs her free drink, grabs a black fleece jacket from the table and darts out of the dot-com party at the San Francisco Museum of Modern Art. She hops into a van with four strangers, who are on their way to another dot-com bash across town. The conversation moves from work to apartments, but conspicuously absent from the chatter is Digital Island the digital content delivery company that spent over $50,000 for food, drink and fleece to fete its new logo and announce a partnership with Apple. In fact, by the time Crolick and her posse reach the second party — a tropical-themed and more raucous affair hosted by Beenz an online currency company — few remember the first company’s name, and no one knows or cares what either company does. Dot-com valuations may have withered, but the enthusiasm for extravagant dot-com parties hasn’t, and party budgets show no signs of being trimmed. In any given week, technology companies throw 15 to 20 parties in the San Francisco Bay Area. On average, each costs $30,000 to $50,000, according to party planners and venue owners, although the $250,000 blowout is hardly rare. In March, for example, Salesforce an online sales automation service, and iCast which offers streaming media tools and content, each ran up tabs greater than $200,000, entertaining more than 1,000 guests each…. Marx, the president of Acteva — which brought 2,000 people to Treasure Island in December for a $200,000 party to announce its new name — agrees. More money, more people and more extravagant ideas are definitely the way to go. It’s no longer enough to just “get a few hundred people together and give them a drink,” he says, glancing around at the paltry WiredPlanet party.”

Clearly an abnormal number of IPOs and unprofitable companies doing an IPO was happening in 1999.

dist ipo

The level of schadenfreude and morbid curiosity was also unprecedented.  The roll call of craziness is long:

FogDog

Pixelon

Startups.com

eToys

Pointcast,

PlanetRX

Blue Mountain

Digiscents

InfoSpace

CyberRebate

iFusion

GovWorks

Beenz

Webvan

Kozmo

GeoCities

Flooz

A more complete list of companies that went public during the DotCom era can be seen in this document entitled: “A Prelude to the Dot-Com Bust” http://online.wsj.com/public/resources/documents/CovOriginal.pdf  What is interesting is that a few companies like Amazon are on this list so some went on to bigger things. It would be interesting if the math revealed yet another power law.

One thing that is hard to describe is how quick things got really ugly. Some people froze like a deer in headlights. Other people acted and salvaged some value. Every day in the market even during less volatile times you are in the lead car of the a roller-coaster and can’t see anything ahead, but because the up and down motion were so very steep in the Dot-Com era the experience was particularly unnerving.

“On March 10, 2000 the combined values of stocks on the NASDAQ was at $6.71 trillion; the crash began March 11. By March 30, the NASDAQ was valued at $6.02 trillion. On April 6, 2000, it was $5.78 trillion.”

By the start of 2000 the investing and business environments weren’t quite as nutty as was the case in 1999 but times were still relatively good. But things went downhill fast that year:

“Unlike 1999, the new issues class of 2000 featured a lot of big losers,” says Richard Peterson, chief market strategist for Thomson Financial Securities Data. Peterson’s firm reports that of the 452 stocks that went public last year, 284, or 63%, trade below their offering prices and 68% are down from the first trading day’s close.

What caused the bubble to pop? In March of 2000 Barron’s carried a story that contained some sobering numbers that some people believe was pivotal in triggering the correction. I am of the views that what triggered the correction was a lack of cash. Was the Barron’s article the last straw on the camel’s back? It is impossible to prove but some people think so. I remember reading the Barron’s story but since I was seeing many Internet companies with little cash on hand the article’s conclusion was not really news. There were telecom companies on that list referred to in the Barron’s article but the telecom world did not see a collapse until early 2001. There were also companies on that list http://online.wsj.com/public/resources/documents/CovOriginal.pdf  like Amazon, Ticketmaster, McAfee and Priceline that survived. In any event, regardless of whether you think the article as the cause of the change, the Barron’s story was very timely and correct:

“An exclusive study conducted for Barron’s by the Internet stock evaluation firm Pegasus Research International indicates that at least 51 ‘Net firms will burn through their cash within the next 12 months. This amounts to a quarter ofthe 207 companies included in our study. Among the outfits likely to run out of funds soon are CDNow, Secure Computing, drkoop, Medscape, Infonautics, Intraware and Peapod. To assess the Internet sector’s financial position, Pegasus assumed that the firms in the study would continue booking revenues and expenses at the same rate they did in last year’s fourth quarter. While this method cannot predict the future precisely, it helps answer a question that has been nagging many stock-market analysts: When will the crowded Internet industry begin to be winnowed? The ramifications are far-reaching. To begin with, America’s 371 publicly traded Internet companies have grown to the point that they are collectively valued at $1.3 trillion, which amounts to about 8% of the entire U.S. stock market.”

These charts of the NASDAQ tell a graphical story about what happened and when. It is important to note that it went down as fast as it went up. One company as I recall ended up stuck with $1B in FPGA chips sitting in warehouses. Everything changed. Quickly. The telecom bubble took at bit longer to correct, but that is another story.

rise

real price

By December 2000:

“What a difference a year makes. The Nasdaq sank. Stock tips have been replaced with talk of recession. Many pioneering dot-coms are out of business or barely surviving. The Dow Jones Internet Index, made up of dot-com blue chips, is down more than 72 percent since March. Online retailers Priceline and eToys, former Wall Street darlings, have seen their stock prices fall more than 99 percent from their highs.”

Philip J. “Pud” Kaplan’s operated a web site that published stories, internal memos and leaked documents of failed startups that still can be found at http://web.archive.org/web/20011201061308/http://fuckedcompany.com/ You can change the date to simulate what it was like to look at the dead pool every day. Posts looked like this:

pud

In terms of my own decisions related to the end of the bubble, the summer of 1999 was when I hedged the market by selling some shares and buying some puts as a proxy hedge after reading a lot of material on the views of Buffett and Munger. I decided that year I would put away enough money in safe bets so I could live comfortably regardless of what happened. There are times in life when the world will not make much sense, at least to you. As an example, the Internet bubble of 1999-2001 was a time like that. The share sales and proxy hedging ensured that I would not be a burden to anyone in my retirement and that my children would be able to go to college with my financial assistance. I did leave a lot of money on the table by not selling everything, but my “barbell portfolio” did what it was designed to do. My decisions were not perfect but they were sound.

barbell

Little Risk (cash and safe bonds)                                   Lots of Risk (startups and tech stocks)

So you may ask, are we in a bubble now? Well we can say that things are very different. The situation today is not the same it was in March 2000. The Economist writes;

“the base of today’s success is broader. In 2000 some 400m people around the world had access to the internet; by the end of 2015 3.2 billion people will. And the internet reaches into these people’s lives in many more ways than it could 15 years ago. ‘Technology is no longer a vertical industry, as it’s been understood by everyone for four decades,’ says John Battelle, a journalist and entrepreneur who launched the Industry Standard, a magazine which reported on the dotcom boom before itself going bankrupt in 2001. ‘Technology is now a horizontal, enabling force throughout the whole economy.’”

I fall in the camp of people who say that we do not have a valuation bubble today but rather a risk bubble. The big lesson to take away from the 2000 bust is that the cash spigot can close really fast. One day you can raise hundreds of millions of dollars and the next day you can’t raise five cents. From the end of the Internet bubble into 2003 cash was indeed king. I remember Greg Maffei telling me that when he was still Microsoft’s CFO as early as 1998. Risk and valuation are not the same. There are many thing that are different now a few of which are noted in this article http://www.valuewalk.com/2017/05/nasdaq-6000-now-infographic/  by Burt White, Chief Investment Officer for LPL Financial

  • Price to Earnings Ratio (PE). The PE ratio for the Nasdaq in March 2000 on current year estimates was 107, versus 23 today. Even using the consensus forward (next 12 months) earnings estimates, the PE stood at 75 back in March 2000 compared with 22 today. The cash flow multiples also tell the same story: near 100 then compared with mid-20s now.
  • Price-to-book ratio. Valuation measures based on the value of company assets minus liabilities, or book value, also reveal a much more expensive Nasdaq in 2000 versus now. The lack of assets supporting valuations was a big problem during the dotcom bubble (page views, eyeballs, and clicks were not enough). The price-to-book ratio at the peak in March 2000 was over 7, compared with 3.9 now (as of April 28, 2017). And those assets today produce far more profits.
  • Market trajectory. Another way to compare today’s Nasdaq to the 2000 version is looking at the steepness of the two rallies, which reveals a dramatic difference. The Nasdaq has gained 22% over the past two years, compared to its 189% surge during the two years leading up to the March 10, 2000 peak. Clearly today’s technology rally lacks the parabolic nature of the dotcom bubble.

Good things can come from bad experience. Many ideas that failed then are succeeding now. Capitalism requires failure and it is an understatement to say that a lot of things failed as a result of the Internet bubble. One good example is described here by CB Insights:  “In 1996, Louis Borders, founder of Borders bookstores (a famous casualty of the modern e-commerce era), had the crazy idea to let people order their groceries online and have them delivered to their homes. To achieve this, Louis Borders raised $396 million through an IPO in late 1999. After several years of sustained losses, though, the company finally crashed in 2001. But Borders’ dream of people never having to leave their homes for groceries has since been adopted by Amazon.” I know several people who loved WebVan as customers and they mourned its demise. But they could not cover their costs (venture philanthropy does not scale) and ran out of cash.

Webvan

Notes:

1999: http://money.cnn.com/1999/12/27/investing/century_ipos/

2000: https://www.forbes.com/2001/01/03/0103sf.html

Mattermark: https://mattermark.com/technology-company-ipos-then-now/

10 years Gone: https://www.cnet.com/news/10-years-gone-the-va-linux-systems-ipo/

A Dozen Lessons on Finance and Business from Ambrose Bierce

Ambrose Bierce started his career as a printer’s devil (apprentice) at an Indiana, paper after he completed about a year in high school. In 1861 he enlisted in the 9th Indiana Volunteers and fought in a number of American Civil War battles, including Shiloh and Chickamauga. He was seriously wounded in the Battle of Kennessaw Mountain in 1864 and served until January 1865.  After the war he worked as an editor, journalist, and short story writer mostly in San Francisco. What would become the book “The Devil’s Dictionary was begun in a weekly paper in 1881, and was continued in a desultory way at long intervals until 1906.  In that year a large part of it was published in covers with the title The Cynic’s Word Book, a name which the author had not the power to reject or happiness to approve.”

Janson Zweig has written a wonderful book entitled The Devil’s Financial Dictionary in the style of Bierce that is both entertaining and educational. My approach in this blog post, as is customary, is to supply something in support of the original text, which in this case a joke rather than the usual commentary.

  1. “OWE, v. To have (and to hold) a debt. The word formerly signified not indebtedness, but possession it meant ‘own,’ and in the minds of debtors there is still a good deal of confusion between assets and liabilities.” 

A frog goes into the bank and asks the teller for a business loan. The teller tells the frog to see Mr. Paddywack, the business loan officer. Mr. Paddywack looks at the frog and says, “What do you have for collateral? The frog pulls out of his pocket a solid silver elephant. Mr. Paddywack looks at the elephant and says, “I don’t know. I’m going to have to ask Mr. Larson, the bank manager to approve this business loan.” He goes into Mr. Larson’s office and comes back. Two minutes later, Mr. Larson comes out with the elephant and says, “It’s a knick-knack Paddywack, give the frog a loan!”

  1. “COMMERCE, n. A kind of transaction in which A plunders from B the goods of C, and for compensation B picks the pocket of D of money belonging to E.” 

A man had just been hired as the new CEO of a large corporation. The CEO who was stepping down met with him privately and presented him with three numbered envelopes. “Open these if you run up against a problem you don’t think you can solve,” he said. Well, things went along pretty smoothly at first, but six months later, sales took a downward turn and he was really catching a lot of heat. About at his wits end, he remembered the envelopes. He went to his drawer and took out the first envelope. The message read, “Blame your predecessor.” The new CEO called a press conference and tactfully laid the blame at the feet of the previous CEO. Satisfied with his comments, the press — and Wall Street — responded positively, sales began to pick up and the problem was soon behind him. About a year later, the company was again experiencing a dip in sales, combined with serious product problems. Having learnt from his previous experience, the CEO opened the second envelope. The message read, “Reorganize.” This he did, and the company rebounded. After several consecutive profitable quarters, the company once again fell on difficult times. The CEO went to his office, closed the door and opened the third envelope. The message said, “Prepare three envelopes.”

  1. “FINANCE, n. The art or science of managing revenues and resources for the best advantage of the manager. The pronunciation of this word with the i long and the accent on the first syllable is one of America’s most precious discoveries and possessions.”

How many stockbrokers does it take to screw in a lightbulb? Two. One to hire a lightbulb installer and another to charge you a fee of 1% of your assets each year and a 5% sales load.

  1. “MAMMON, n.: The god of the world’s leading religion.” (can be defined as money, material wealth, or any entity that promises wealth.”

Two friends met in the street. One looked sad and almost on the verge of tears. The other man said, “Hey my friend, how come you look like the whole world has caved in?”  The sad fellow said, “Let me tell you. Three weeks ago, an uncle died and left me $50,000.” “That’s not bad at all…!” “Hold on, I’m just getting started. Two weeks ago, a cousin I never knew died and left me $95,000.” “Well, that’s great! I’d like that.” “Last week, my grandfather passed away. I inherited almost $1 million.” “So why are so glum?” “This week – nothing!”

  1. “PROPERTY, n. Any material thing, having no particular value, that may be held by A against the cupidity of B. Whatever gratifies the passion for possession in one and disappoints it in all others.” 

A man opened the door of his BMW, when suddenly a car came along and hit the door, ripping it off completely. When the police arrived at the scene, the lawyer was complaining bitterly about the damage to his precious BMW. “Officer, look what they’ve done to my Beeeemer!!!”, he whined. “You are so materialistic. You make me sick!!!” said  the officer, “You’re so worried about your stupid BMW, that you didn’t even notice that your left arm was ripped off!” “Oh my gaaad….”, replied the man, finally noticing the bloody left shoulder where his arm once was, “Where’s my Rolex? ”

  1. “MONEY, n. A blessing that is of no advantage to us excepting when we part with it. An evidence of culture and a passport to polite society. Supportable property.” 

A thief stuck a pistol in a man’s ribs and said, “Give me your money.” The man replied, “You cannot do this — I’m a United States congressman!”  The thief said, “In that case, give me my money!”

  1. “CLAIRVOYANT, n.: A person who has the power of seeing that which is invisible to her patron – namely, that he is a blockhead.”

While studying the occult, a teacher asked one of the boys in her class, “Can people predict the future with cards?” His response was, “My mother can.” The teacher replied, “Really?” The young boy was quick to explain, “Yes, she takes one look at my report card and tells me what will happen when my father gets home.”

  1. “BRAIN, n. An apparatus with which we think that we think.” 

An alien walked into a shop and told the owner that he came from Mars and wanted to buy a brain for research. ”How much is this one?” he asked. ”That one is a monkey brain, and it’s $20,” the owner explained. ”How much is that one?” the alien asked. “That one is an engineer’s brain, and it’s $100,” the owner replied. ”And how much is that one?” the alien asked. ”That one is a politician’s and it is $500” the owner explained. ”Why is the politician’s brain so expensive?” the alien asked. The owner answered, ”Well, it’s hardly been used!”

  1. “PLAN, v.t. To bother about the best method of accomplishing an accidental result.”

A girl has brought her fiancé home for dinner. After dinner, the fiancé and the girl’s father go into the study for a man to man talk. “So, what are you doing right now?” asks the father. “I am a theology scholar,” replies the fiancé. “Do you have any plans of employment?” “I will study and God will provide.” “What about the children?” asks the man. “God will provide.” “And your house and car?” “Again, God will provide,” says the fiancé. After the talk, the girl’s mother asks the father, “So what did you two talk about?” The man replies, “He has no plans of employment, but on the other hand, he thinks I’m God.”

  1. “RESPONSIBILITY, n. A detachable burden easily shifted to the shoulders of God, Fate, Fortune, Luck or one’s neighbor. In the days of astrology it was customary to unload it upon a star.”

Joe was having a tough time finding a job what with the current economic problems. He couldn’t even get an interview. Finally, he secured an interview and needless to say, he was trying his best to impress. The interviewer said, “In this job Joe, we need someone who is responsible.” “I’m the one you want,” Joe replied. “At my last job every time anything went wrong, they said I was responsible.”

11.“CONSULT, v.i. To seek another’s disapproval of a course already decided on.”

A shepherd was herding his flock in a remote pasture when suddenly a brand-new BMW advanced out of the dust cloud towards him. The driver, a young man in a Brioni suit, Gucci shoes, Ray Ban sunglasses and a silk tie, leaned out the window and asked the shepherd… “If I tell you exactly how many sheep you have in your flock, will you give me one?” The shepherd looked at the man, obviously a yuppie, then looked at his peacefully grazing flock and calmly answered “sure”. The man parked his car, whipped out his laptop and connected it to a mobile phone, then he surfed to a NASA page on the internet where he called up a GPS satellite navigation system, scanned the area, and then opened up a database and an Excel spreadsheet with complex formulas. He sent an email and, after a few minutes, received a response. Finally, he prints out a 130-page report, then turns to the shepherd and says, “You have exactly 1586 sheep. “That is correct; take one of the sheep.” said the shepherd. He watches the young man select one of the animals and bundle it into his car. Then the shepherd says: “If I can tell you exactly what your business is, will you give me back my animal?”, “OK, why not.” answered the man.” Clearly, you are a consultant.” said the shepherd. “That’s correct.” Says the man, “but how did you guess that?” “No guessing required.” Answers the shepherd. “You turned up here although nobody called you. You want to get paid for an answer I already knew, to a question I never asked, and you don’t know crap about my business. Now give me back my dog.”

  1. “BORE, n. A person who talks when you wish him to listen.”

“I’m bored’ is a useless thing to say. I mean, you live in a great, big, vast world that you’ve seen none percent of. Even the inside of your own mind is endless; it goes on forever, inwardly, do you understand? The fact that you’re alive is amazing, so you don’t get to say ‘I’m bored.”  Louis C.K.

Notes:

The Devil’s Dictionary http://xroads.virginia.edu/~Hyper/Bierce/bierce.html#L

The Devil’s Financial Dictionary By Jason Zweig  https://www.amazon.com/Devils-Financial-Dictionary-Jason-Zweig/dp/1610396995

Tech version: http://www.theverge.com/a/new-devils-dictionary

How to Make Decisions like Ray Dalio

What is most interesting to me about Ray Dalio is his decision-making process. This blog post is limited to a discussion of that process and not Bridgewater’s philosophy generally. If you are interested in understanding Bridgewater and Dalio more broadly, Dalio has a book coming out this fall which expands on his widely circulated “Principles” document.  I have written a more general blog post about Dalio on this blog, which you can find a link to in the Notes to this post.

Anyone who has read and understood the books and essays of Michael Mauboussin knows that people who have a sound decision-making process have better outcomes in life (not just in investing). Dalio’s view tracks Mauboussin’s view: “I think that every single day there are many decisions that people make and they all have consequences. And your life essentially depends on the cumulative quality of the decisions you make.” Having said that about the importance of making wise decisions in all aspects of life, thinking about how Dalio makes investment decisions is a particularly effective way of understanding his process. These quotations from Dalio set the table for a discussion of his decision-making process:

“You have to be an independent thinker in markets to be successful because the consensus is built into the price. You have to have a view that’s different from the consensus.” 

“To win at stocks or entrepreneurship, you must bet against the consensus and be right.”

Andy Rachleff makes the same point as Dalio is saying in this way: “Investment can be explained with a 2×2 matrix. On one axis you can be right or wrong. And on the other axis you can be consensus or non-consensus. Now obviously if you’re wrong you don’t make money. The only way as an investor and as an entrepreneur to make outsized returns is by being right and non-consensus.”

matrixra

Another adherent to this idea is Howard Marks who has said: “To achieve superior investment results, your insight into value has to be superior. Thus you must learn things others don’t, see things differently or do a better job of analyzing them – ideally all three.” Being genuinely contrarian means the investor is going to be uncomfortable sometimes. Some people are good at being uncomfortable, and some are not.

Dalio believes:  

“Most other professions you can build on existing knowledge. You don’t have to have a point of view. If you’re a doctor and somebody breaks a leg or whatever, you can repair that leg. It’s not zero-sum, in the sense that you have to be smarter than the next person or different from the consensus. Now in order to be different from the consensus, there’s a high risk you’re going to be wrong.”

“Find people of alternative points of view and have quality conversations back and forth. Not to let them think for me, not for me to follow their point of view, but for me to understand the different perspectives. Because it increases my probability of being right, and it reduces my probability of being wrong.”

“When you have a view that’s different from the consensus, you’re gonna be wrong a certain number of times.  It teaches you humility.  The most important thing is to have humility and to think about ‘how do I get the best decision?’ It doesn’t have to come from me, I just want to be right.”

“Decision-making should be two steps. The first step is taking in information, particularly if there is disagreement, to understand that disagreement and then to make a decision. You have your right to make a decision. But it is so stupid not to take the time to take in and explore disagreement that might help prevent yourself from being wrong.”

The desire to explore disagreement is the foundation of Dalio’s drive to create “radical transparency”? Dalio describes this concept as follows:

“I want an idea meritocracy.  I want independent thinkers who are going to disagree.  The most important thing I want is meaningful work and meaningful relationships and the way to get that is through radical transparency.”

“Meaningful work is being on a mission that you’re excited about and that you can get your head into. And in meaningful relationships you can be totally transparent with each other, letting each other know what your weaknesses are.”

As context, what Dalio is setting out to do as an investor is extraordinarily hard. To say that a tiny number of people outperform the markets by making macro bets is a radical understatement. A handful of people have been able to do this successfully over many years at scale. Dalio has discovered a source of alpha (outperforming a benchmark) through a process that results in better decisions.

Here is my short “boil the ocean” description of his decision making process: Dalio starts with a rational analysis of the information he has and from that he forms a hypothesis. He then exposes that hypothesis to thoughtful people with alternative points of view and methods of analysis who may disagree with him and then he wants a radically transparent “back and forth” discussion. As part of that process he wants to deeply understand the reasoning of any thoughtful opposing views. Only after he has understood these alternative points of view does Dalio believe he is in a position to reject or accept the alternative ideas and make a decision. Dalio’s approach is quite similar to Charlie Munger’s approach: “I never allow myself to have an opinion on anything that I don’t know the other side’s argument better than they do. Rapid destruction of your ideas when the time is right is one of the most valuable qualities you can acquire. You must force yourself to consider arguments on the other side.”

Why would Dalio join Twitter this week? Well, if you do use Twittter properly you can get exposed to real time views of smart people who think differently and who may have opposing views. He seems to understand a key point about Twitter’s value when he tweeted this past week: “Look forward to learning from my mistakes in a whole new way.” Bob Lefsetz explains why Twitter is so unique:

twitter1

Twitter2

Many people treat Twitter as a broadcast medium which is a shame since the value of interactive discussion is so much higher. Many people also turn their Twitter feed into a echo chamber, which is a lost opportunity. Jason Zweig has a great column this week where is describes why “Investors have a hard time looking the truth square in the face” and the creation of echo chambers of all kinds makes the problem worse.

Dalio and Munger share other approaches to decision-making. For example, Munger, who describes his process as follows: “I use a kind of two-track analysis. First, what are the factors that really govern the interests involved, rationally considered? The first track is rationality-the way you’d work out a bridge problem: by evaluating the real interests, the real probabilities and so forth. Second, [I work to eliminate] influences where the brain at a subconscious level is automatically doing these things-which by and large are useful, but which often malfunctions.” Munger and Buffett also have a third step in their decision-making process that is similar to Dalio: expose their ideas to the best minds they can find. In Buffett’s case that mind is almost always Charlie Munger. Buffett calls Munger the “Abominable No Man.” Buffett exposing an investing hypothesis to Munger is like tempering steel    if an investing hypothesis doesn’t break after being exposed to Munger it is more likelky to be sound.

Having a diverse “posse” of experienced people that you trust look at a potential investment is wise if you want to avoid making too many mistakes. Philip Fisher, an investor who Munger and many other investors learned a lot from, maintained a “scuttlebutt” network of people who he would call for advice or expertise, Munger has said: “Even Einstein didn’t work in isolation. But he never went to large conferences. Any human being needs conversational colleagues.” Buffett once gave a huge compliment to Munger’s value as a person who can stress test his ideas when he said: “I try to look out 10 or 20 years when making an acquisition, but sometimes my eyesight has been poor. Charlie’s has been better; he voted ‘no’ more than ‘present’ on several of my errant purchases.”

To review what I have said in this post so far, the decision making process that Dalio, Buffett and Munger use is:

(1) make the most rational decisions you can;

(2) look for psychological bias that may have interfered with making a rational decision; and

(3) expose your hypothesis to very smart people who have a thoughtful contrary view and deeply understand their position.

On this last point Daniel Kahneman believes: “To better avoid errors, you should talk to people who disagree with you and you should talk to people who are not in the same emotional situation you are.”

Dalio believes that the more a person repeats this process over the years, the more they learn. What does this sound like to you? It is essentially what Munger calls “Worldly Wisdom.” Dalio sounds very much like Munger here:

“What I’ve discovered in that process is that I was learning so much. So just imagine what a fantastic path to think.” “Let me go after the person who has got the opposite point of view, who is really smart, and let me have quality conversations, quality disagreement.” “I get clear feedback. The goal is: don’t be too wrong. Be more right than wrong. So in that process I can take personal accountability. If I don’t learn personal accountability, if I don’t learn, then I’m going to pay a terrible price. So that process itself lent itself to this kind of very open-minded decision. Also the making mistakes, and the loving the mistakes.”

“There’s an art to this process of seeking out thoughtful disagreement. People who are successful at it realize that there is always some probability they might be wrong and that it’s worth the effort to consider what others are saying — not simply the others’ conclusions, but the reasoning behind them — to be assured that they aren’t making a mistake themselves. They approach disagreement with curiosity, not antagonism, and are what I call ‘open-minded and assertive at the same time.’ This means that they possess the ability to calmly take in what other people are thinking rather than block it out, and to clearly lay out the reasons why they haven’t reached the same conclusion. They are able to listen carefully and objectively to the reasoning behind differing opinions. When most people hear me describe this approach, they typically say, ‘No problem, I’m open-minded!’ But what they really mean is that they’re open to being wrong. True open-mindedness is an entirely different mind-set. It is a process of being intensely worried about being wrong and asking questions instead of defending a position. It demands that you get over your ego-driven desire to have whatever answer you happen to have in your head be right. Instead, you need to actively question all of your opinions and seek out the reasoning behind alternative points of view.”

Dalio’s famous principles document provide a guide to decision making at Bridgewater. Many of these principles you have seen other investors say on this blog. For example:

“190) Recognize the Power of Knowing How to Deal with Not Knowing

191) Recognize that your goal is to come up with the best answer, that the probability of your having it is small, and that even if you have it, you can’t be confident that you do have it unless you have other believable people test you.

192) Understand that the ability to deal with not knowing is far more powerful than knowing a) Embrace the power of asking: ‘What don’t I know, and what should I do about it?’ b) Finding the path to success is at least as dependent on coming up with the right questions as coming up with answers.

193) Remember that your goal is to find the best answer, not to give the best one you have.

194) While everyone has the right to have questions and theories, only believable people have the right to have opinions

195) Constantly worry about what you are missing. a) Successful people ask for the criticism of others and consider its merit. b) Triangulate your view.

196) Make All Decisions Logically, as Expected Value Calculations

197) Considering both the probabilities and the payoffs of the consequences, make sure that the probability of the unacceptable (i.e., the risk of ruin) is nil. (a) The cost of a bad decision is equal to or greater than the reward of a good decision, so knowing what you don’t know is at least as valuable as knowing. (b) Recognize opportunities where there isn’t much to lose and a lot to gain, even if the probability of the gain happening is low. (c) Understand how valuable it is to raise the probability that your decision will be right by accurately assessing the probability of your being right. (d) Don’t bet too much on anything. Make 15 or more good, uncorrelated bets.”

What typically gets in the way of the process like Dalio wants to create? Ego and organizational politics.

A. The ego of the decision maker is so often the source of a problem or mistake. Dalio says that it is emotionally hard to be radically transparent.  Warren Buffett writes: “It’s ego. It’s greed. It’s envy. It’s fear. It’s mindless imitation of other people. I mean, there are a variety of factors that cause that horsepower of the mind to get diminished dramatically before the output turns out. And I would say if Charlie and I have any advantage it’s not because we’re so smart, it is because we’re rational and we very seldom let extraneous factors interfere with our thoughts. We don’t let other people’s opinion interfere with it… we try to get fearful when others are greedy. We try to get greedy when others are fearful. We try to avoid any kind of imitation of other people’s behavior. And those are the factors that cause smart people to get bad results.” What Buffett describes is an example of what Charlie Munger calls inversion. Instead of just trying to be smart, it is wise to focus on not being stupid. Dalio believes:

“People are so attached to being right, and yet the tragedy is it could be so easy to find out how you’re wrong. If you just said to yourself, “I’m not sure that I’m right, and let me go find people who have alternative point of views and let me have quality conversations.” Not to pay attention to their conclusions, but to the thought process. So thoughtful discussion, worrying about being wrong but not to the sense of being paralyzed. Or moving forward, but in the sense of trying to create discovery, to have an exchange. To go after the person who has the most different point of view, who is the most thoughtful, and then have a conversation to see their point of view. Whether a person could be both open-minded and assertive at the same time, that creates a discovery process. It creates a fabulous learning. That process itself reduces the probability of being wrong and produces a great deal of learning. People are so hung up on being right. Starting their discussion and deriving some sort of satisfaction if, at the end of the discussion, they were where they began the discussion. That doesn’t make any sense, because there’s not going to be any learning. So ego plays an important role in that. The people that feel like, ‘I’m good. I’ve got it,’ won’t learn. If you’ve got it, you won’t learn. So you have to get rid of this ego barrier, ‘I’ve got it’ thing.”

“You start to learn how people see things differently. And rather than just seeing how you see it, you go above that. You’re seeing that everybody is seeing things differently. It changes how you see things because it starts to make you think, how do I know I’m not the wrong one? You start to think, how do I collectively see? And it’s like being in a different color range. All of the sudden you see the full spectrum. When you start to realize that people are actually seeing in those [different] ways — that it’s a valid way of seeing, and that I need you and you need me — it gives you the evidence base that it’s okay to be different. The most important thing is to have humility, and to think about, how do I get the best decision? It doesn’t have to come from me. I just want it to be right, right? If comes from other people, that’s good. The greatest tragedy of mankind is people holding on to wrong opinions that could so easily be rectified and that are doing them harm because they’re making wrong decisions.”

B. Organizational politics. One advantage that Buffett and Munger have is that in many cases the “radically transparent” discussion is just between the two of them. Both Buffett and Munger have said that they sometimes disagree but have never had “an argument” that was hostile. They have also decided to focus on investing decisions that involve forecasts about microeconomics. In contrast, Dalio is engaged in macro investing and his supporting organization is far larger. Reuters describes what must be managed at Bridgewater as follows:

“Bridgewater manages about $160 billion, according to its website, and is known for a unique culture of ‘radical truth and radical transparency’ whereby intellectual conflict is encouraged to promote a meritocracy of ideas, avoiding traditional office politics. The culture is not for everyone. The firm is known for relatively high turnover among its roughly 1,700-person staff. An estimated 25 percent depart during the first 18 months of employment.”

The challenges associated with maintaining a culture like Bridgewater which is willing to incur the overhead of continuously providing feedback and utilizing it in decision-making in an idea meritocracy are significant. The number of connections between employees increases with the square of the number of involved employees, which has caused Dalio to come up with some unusual approaches to maintaining radical transparency like videotaping and making available to anyone almost all meetings and the use of Bridgewater designed baseball cards. It is precisely because what Dalio is doing at Bridgewater is so hard that Bridgewater’s alpha has been persistent. If doing what Bridgewater does was easy, the alpha would disappear. Being different is a source of competitive advantage. If you want different results you must act in a different way.

To see how Dalio tries to combat dysfunctional corporate politics at Bridgewater it is useful to examine how he describes his principles:

“Never say anything about a person you wouldn’t say to him directly. If you do, you’re a slimy weasel. Badmouthing people behind their backs shows a serious lack of integrity. It doesn’t yield any beneficial change and it subverts both the people you are bad mouthing and the environment as a whole. Next to being dishonest, it is the worst thing you can do at Bridgewater. Criticism is both welcomed and encouraged at Bridgewater, so there is no good reason to talk behind people’s backs. You need to follow this policy to an extreme degree to be in harmony with our culture. For example, managers should not talk about people who work for them without those people in the room.” “So every meeting is taped and made available for everybody in the company to look at. And all we have are conversations of, ‘What makes sense?” Everybody has the right to make sense of things. Now in that environment I get to see how differently people think. I realize how radically different people think.”  “This approach comes to life at Bridgewater in our weekly research meetings, in which our experts on various areas openly disagree with one another and explore the pros and cons of alternative views. This is the fastest way to get a good education and enhance decision-making. When everyone agrees and their reasoning makes sense to me, I’m usually in good shape to make a decision. When people continue to disagree and I can’t make sense of their reasoning, I know I need to ask more probing questions or get more triangulation from other experts before deciding. I want to emphasize that following this process doesn’t mean blindly accepting the conclusions of others or adopting rule by referendum. Our CIOs are ultimately responsible for our investment decision-making. But we all make better decisions by maintaining an independent view and the conflicting possibilities in our minds simultaneously, and then trying to resolve the differences. We’re always in the place of holding an opinion and simultaneously stress-testing the hell out of it. Operating this way just seems like common sense to me. After all, when two people disagree, logic demands that one of them must be wrong. Why wouldn’t you want to make sure that that person isn’t you?”

This sort of total honesty and transparency is not a comfortable environment for many people, but it is for enough talented people that Bridgewater has been able to assemble its team and compile its remarkable investing record. If you want to dig into radical transparency and issues like how ego and emotions can get in the way of Dalio’s approach to making decisions, I suggest you watch “The Culture Principle” video linked second in the Notes below.

Notes:

Dalio Essay http://www.institutionalinvestor.com/blogarticle/3433519/bridgewaters-ray-dalio-explains-the-power-of-not-knowing.html#.WPcD9YWcFNs

The Culture Principle https://www.youtube.com/watch?v=h2KHec3KNyQ

Dalio Interview:  http://prodloadbalancer-1055872027.us-east-1.elb.amazonaws.com/autodoc/page/dal1int-1

Bridgewater Principles:  https://docs.google.com/viewer?a=v&pid=sites&srcid=ZGVmYXVsdGRvbWFpbnxlYm9va3Nkb3dubG9hZG5vdzIwMTZ8Z3g6MjY3NGU2Njk5N2QxNjViMg  and https://www.bridgewater.com/#principles-culture

New Yorker Profile: http://www.newyorker.com/magazine/2011/07/25/mastering-the-machine

A Dozen Things Essay by me about Dalio: https://25iq.com/2013/10/12/a-dozen-things-ive-learned-from-ray-dalio-about-investing/

Radical Transparency Essay: https://www.forbes.com/sites/eriklarson/2017/04/04/decision-making-guru-ray-dalio-radical-transparency-buddha/2/#6eef6f63112c

The Rise of the Freemium Business Model

 

Freemium describes a business model in which a business gives one product away for free or at a subsidized price and then either: (1) sells another profitable product to this user base; or (2) sells access to that user base to third parties (e.g., advertisers). Three versions of the Freemium approach are:

  1. Available Forever- No premium versions are made available. Google and Facebook are examples that monetize with advertising.
  2. Premium Freemium: Users pay only for premium versions (e.g., more powerful features or greater use rights). Only the free baseline version is “available forever.” LinkedIn and TurboTax are an examples.
  3. Limited Freemium: The free version is made available but is limited by factors like time and/or capacity. One example would be a 30 day trial with no “available forever” baseline version.

The freemium business model is ancient. A bar giving away salty snacks to sell more  alcohol is nearly as old as the still that created the liquor. The practice of offering tapas in Spain is just one relatively modern example. Newspapers being used to sell political views is another example:

“Gerald J. Baldasty’s book, The Commercialization of News in the Nineteenth Century, makes a case clear as spring water that hard news has almost never been a mass commercial enterprise. The American newspapers of the 1820s and early 1830s were creatures of political parties, edited by zealots. Essentially propaganda sheets, these newspapers were “devoted to winning elections …Many subscribers simply did not pay for their newspapers,” Baldasty wrote.  “In 1832, one North Carolina editor estimated that only 10 percent of his 600 subscribers had paid for the paper.”

Many businesses have offered free services (free month of HBO) or free trials (magazines). The Venture capitalist Tomasz Tunguz of RedPoint has written about why the freemium business model works so well:

“At its core, freemium is a novel marketing tactic that entices new users and ultimately potential customers to try a product and educate themselves about its benefits on their own. By shifting the education workload from a sales team to the customer, the cost of sales can decrease dramatically… freemium startups leverage usage data to improve their product. The large amount of users using the product enables A/B testing with statistical significance, a non-trivial strategic advantage. Marketing teams can sift through the data to understand market segmentation and funnel efficiency, and product management can parse the data to improve the on-boarding experience. Third, freemium startups gather information about their customer base to prioritize their sales efforts.”

The cost of educating the potential customer about the benefits of the product can be dramatically lower once a potential customer has used the product in the free setting. The need for advertising to create awareness is lower and any expenses associated with a paid salesperson or sales support engineer patiently explaining the product to a potential customer has been replaced by self-education. Freemium also leverages other human tendencies like reciprocity and inertia, which further lower the cost of sale. John Vrionis of Lightspeed Venture Partners describes the less costly and more effective freemium sales process:

“Evangelizing a new religion is hard work, and more importantly it is expensive. But that’s essentially what selling proprietary software is like. Conversely, selling bibles to a group of believers is a lot easier… Sales people engage an account when they know that the prospect is well down the path of adoption and belief.”

In some settings the salesperson can be eliminated completely as the customers “upsell” themselves with self-service capabilities of the company web site.

As Tungus and Vrionis note, the essence of the Freemium model is to reduce the price of acquiring a customer. My post “Why is Customer Acquisition Cost (CAC) like a Belly Button?” is an introduction to the topic of CAC. Everyone with a business has CAC.

To illustrate, even comedians must incur costs to acquire customers. As an example, here a famous few sentences from a monologue form the comedian Louis C.K:

“Everything is amazing right now and nobody’s happy. In my lifetime the changes in the world have been incredible. When I was a kid we had a rotary phone. We had a phone you had to stand next to and you had to dial it. And then when, if you wanted money you had to go in the bank for when it was open, for like three hours.”

Those four sentences solidified Louis C.K.’s reputation as an A-List comic. The comedian’s monetization was indirect as is often the case today:

“Comedians today are more likely to gain fame via a YouTube skit or a bit that plays well on a talk show. (Louis C.K.’s most famous monologue, “Everything’s amazing and nobody’s happy,” happened in a sit-down interview with Conan O’Brien).”

Since Louis C.K. is a member of the Screen Actors Guild he would have received at least the union minimum wage to be on O’Brien’s show, but that is a tiny fraction of the value that monologue created for his career. Louis C.K. essentially gave away that monologue for free. In this case one activity (the Conan O’Brien appearance) is being used as a substitute for customer acquisition cost (CAC) for other products like his concerts. This cross promotional approach is not new. Especially for comedians. Not too long ago they generated most of their profit from albums (promoted on talk shows) and concerts (Johnny Carson used to tell people their dates).

Are other comedians using freemium like Louis C.K.? Yep. But the loss leader is not always a zero revenue gig, just lower revenue.

“Comics [have] realized how a constant presence on Netflix, as opposed to sporadic broadcasts on linear television, could help build a larger loyal audience. For most comedians, specials are a means to boosting their key revenue source: regular ticket sales on the road. TV specials have always translated into additional fans showing up on tour stops, but the lift from a Netflix special exceeded what a lot of comics were seeing from regular TV. “The amount of time it took to see the bump was drastically reduced from years to … six or seven months after an artist’s special is on Netflix,” says Volk-Weiss. “Their touring business goes up by hundreds of [percent].”

Wait!” You are probably saying, “People have done free promotions forever.” That’s true, but with the digitalization and networking of the world this freemium phenomenon has been put on steroids. Ben Thompson succinctly describes one root cause of why the Freemium phenomenon is on the rise as a customer acquisition technique as the world become more digital and networked:

“The defining characteristic of anything digital is its zero marginal cost. Take apps for example: What makes the software market so fascinating from an economic perspective is that the marginal cost of software is $0. After all, software is simply bits on a drive, replicated at the blink of an eye. Again, it doesn’t matter how much effort was needed to create said software; that’s a sunk cost. All that matters is how much it costs to make one more copy – $0. The implication for apps is clear: any undifferentiated software product, such as your garden variety app, will inevitably be free. This is why the market for paid apps has largely evaporated. Over time substitutes have entered the market at ever lower prices, ultimately landing at their marginal cost of production – $0.”

In addition to being reproducible and distributable at virtually zero marginal cost, digital goods typically do not have the two qualities described here by Brad DeLong:

“Excludability: the ability of sellers to force consumers to become buyers, and thus to pay for whatever goods and services they use.

Rivalry: a structure of costs in which two cannot partake as cheaply as one, in which producing enough for two million people to use will cost at least twice as many of society’s resources as producing enough for one million people to use.”

If I make a digital copy of your digital music, you still have your music (the music is non-rival). If I steal your phone you will no longer have a phone (a phone is rival). So-called “public goods” are non-rival and non-excludable. A lighthouse is a public good and in many settings so is software. If a business can’t charge customers a fee directly for a good or service since it is a public good giving it away is “sleeves off its vest.” In other words, the real opportunity cost of the sales incentive is zero if the business can’t charge a fee for it anyway.

One confusing element of a freemium business model is the accounting involved. If giving away goods or services for free or with a subsidy is not a marketing expense, what exactly is it? Marketing costs are typically shown below the gross margin line on an income statement. But the cost of freemium offerings can be considered part of costs of goods sold or COGs. Different companies treat freemium costs in different ways. Some companies even split the difference: the cost of non-converted non-paying customers is a marketing expense and the cost of serving paying customers is COGS. In any event, giving away free services is an expense however you look at it.

Small startups with little cash on hand or that desire not to dilute their ownership too much by raising more cash have found freemium to be particularly attractive. If they know how to write software they can use the free service to avoid spending cash on customer acquisition. As an added benefit, customers acquired though freemium tend to value the product more. They churn less from the service and tend to have better credit. Of course freemium can be taken too far, especially if there isn’t a profitable complementary good that can be paired with the service. With internet scale services, while the incremental cost of a new customer/user is not zero (as per Ben Thompson’s description of digital goods) it is effectively zero as there is so little incremental cost. An exception would be highly resource intensive services such as live streaming, email/file storage, or translation all of which use significant bandwidth, storage, or compute per incremental use.

Bill Gurley describes an increasingly important phenomenon facing every business today: “If a disruptive competitor can offer a product or service similar to yours for ‘free’ and if they can make enough money to keep the lights on, then you likely have a problem.” Every businesses today must be prepared for competitors to give away what they sell as an incentive for customers to buy something else. That fact thatmany of the free services are digital and have close to zero marginal costs has caused the freemium strategy to spread like wildfire. The implications of the freemium business model are massive since businesses now face competition from companies that they never previously thought of a competitors. Fred Wilson believes: “when network effects matter, when your users are creating the content and the value, free is the business model of choice.” If the network effects benefits of size are large getting big fast is hard given customers acquisition cost. And the best way to lower customer’s acquisition costs is often free. Making the approach even more attractive is the fact that even free users add to network effects since they are using the systems and its formats.

Using a freemium approach can be tricky in an enterprise setting. Version One ventures points out that freemium can create problems and is not a panacea:

“Offering an app/service for free can send the wrong message. Here, free can be equated with low quality. Free isn’t necessarily sustainable with B2B. Acquiring business users may prove too costly, forcing start-ups to raise incredible amounts of money to finance aggressive sales and marketing efforts for a free app. In the enterprise, freemium models generally work in two situations: (1) You target a large enough user base and (2) The product becomes more valuable over time.”

Freemium works best when there are millions of potential customers since the conversion rate will not be high. Best practices include:

  1. Avoid selecting “free” items that have significant variable COGs. Select software-based free services that have almost zero marginal cost works better.
  2. The best free services have network effects.
  3. Make sure that the item you select as free side of the marketplace has complementary services that might be sold at a profit. Free checking at a bank is good example of free service that makes upselling natural (many types of loans).
  4. The best forms of Freemium make it natural for the users to register revealing their personal data and set up a credit card on file.
  5. The best complementary products are services that people are accustomed to paying real money for (convincing people to spend money in a new category is not easy),
  6. The best free services have low churn since they are sticky)

What sort of conversion rates are typical in a freemium model? One estimate from Totango is:

“For a B2B SaaS company with free trial, I assume the following ball park figures:

3%-5% – average and means good business operations
8% and above – excellent conversion rates
below 3% – below average.”

Nothing creates a base from which to try to up-sell users like a free service.  There is no question that a price of zero is magical for humans. Work by Dan Ariely proves this point:

“In one study we offered students a Lindt Truffle for 26 cents and a Hershey’s Kiss for 1 cent and observed the buying behavior: 40 percent went with the truffle and 40 percent with the Kiss. When we dropped the price of both chocolates by just 1 cent, we observed that suddenly 90 percent of participants opted for the free Kiss, even though the relative price between the two was the same. We concluded that FREE! is indeed a very powerful force.”

Ariely concludes: “‘Free’ is kind of an incredibly tempting human hot button. And sometimes it’s great and sometimes it gets us into trouble.”   

The freemium approach is now scalable globally as never before. The implications of this shift are huge and still being sorted out.

P.s., How much is being given away by producers in consumer settings as a result of the freemium phenomenon? Since free products have no price they are not easy to measure, One indication that the number is large is the fact that 98% of App Store revenue is coming from freemium apps. Services like mobile games and Craigslist have free elements.

  • A Deloitte Report summarizes some of the research in consumer settings:

“Researchers at the University of Michigan found that they saved 15 minutes by using the internet compared to the university library to answer a list of specific questions. Assigning a monetary value to these time savings Google’s Chief Economist, Hal Varian, estimated that the search feature of the internet generates a consumer surplus in the US of $65-130 billion a year. This is likely to significantly underestimate the true level of saving because in this experiment the internet was compared with a university library – an asset that few consumers can access. Another approach is to estimate the time people spend on the internet. The reasoning runs that if I choose to spend an evening searching the web it demonstrates that I prefer this activity to all others available to me. Using this approach Erik Brynjolfsson and Joo Hee Oh at MIT estimated America’s consumer surplus from the internet at $564bn in 2011. Inclusion of this surplus in America’s GDP numbers would have boosted annual growth by a sizeable 0.4 percentage points – equivalent to a 15% uplift in trend growth.  The nature of the internet and the way we interact with it makes estimating the consumer surplus from it incredibly difficult. Crowdsourced websites such as Twitter, Wikipedia, TripAdvisor or the review section of Amazon are particularly challenging. How does one measure the addition to the consumer surplus from our receiving advice, ideas and information?”

These estimates do not include the value of open source and other public goods for businesses such as free cloud compute and storage for commercial customers. For example, every cloud company now has a free tier. Azure also has free credit for new customers and a free service trier.  Amazon has both an always free trier and a first-12-months-free offer. Google also has a free to use tier for its cloud services. In 2015 GetApp, a company that tracks over 3,000 business apps, reported that 22% of the total have adopted a freemium model. Business like DropBox, Slack, MailChimp, SoundCloud, EverNote, ZoHo, SurveyMonkey, Skype, HootSuite, Moz, Weebly, Salesforce, Optimizely, and Box all use a freemium approach. Open source examples include Linux, Git, MySQL, Node.js, Docker, Hadoop, Elasticsearch,  Spark,  MongoDB, Selenium, NPM, Redis,  Tomcat, Jenkins, Vagrant, Postgres, Gradle, Nginx, Ansible,  Kafka, GitLab, and Chef.

Open source software has enabled the creation of many freemium business models. By combining software that is given away as part of an open source community with related proprietary services that are not given away, a new business model is created. The related profitable and proprietary services must “complement” the free service like mustard complements a hot dog for the model to work well. Many entrepreneurs and investors have realized that the best path in creating a new business is to invent an open source project that is widely contributed to and then build a service around it after hiring all the people who worked on it. Businesses that have been built around open source, like Databricks, Mesosphere, and Docker, exemplify this trend.

Notes:

Louis C.K. https://www.youtube.com/watch?v=q8LaT5Iiwo4

Ben Thompson https://stratechery.com/2014/cost-bitcoin/

Deloitte: http://blogs.deloitte.co.uk/mondaybriefing/2015/09/weve-never-had-it-so-good.html

DeLong  http://delong.typepad.com/hoisted_from_the_archives/2007/11/j-bradford-delo.html

John Vrionis: http://venturebeat.com/2015/12/06/its-actually-open-source-software-thats-eating-the-world/

Jack Shafer: News never made money, and is unlikely to.  http://blogs.reuters.com/jackshafer/2013/08/15/news-never-made-money-and-is-unlikely-to/

Tomasz Tunguz http://tomtunguz.com/when-to-go-freemium/

Version One: http://versionone.vc/freefreemium-work-enterprise/#ixzz4eNwf7zE0

Fred Wilson: http://avc.com/2012/07/in-defense-of-free/

A Dozen Lessons about Business Valuation from the Iridium Debacle

 

One of the best illustrations of the many ways a business valuation can go wrong is the pre-bankruptcy story of mobile satellite service Iridium. I knew Iridium  well since I did potential acquisition due diligence on Iridium several times and because people who worked for Craig McCaw had a long history with Motorola. We (Eagle River) always passed on buying Iridium no matter how low the price dropped. The potential upside of buying Iridium even for $1 was tiny, but the potential downside (especially the opportunity cost) was massive. We already had enough wholesale transfer pricing and other problems with Motorola related to Nextel.

There is a recent book about Iridium, but that account does not identify why such colossal mistakes were made in assessing the potential value of the business. The common narrative is:

“John Bloom, an investigative journalist and author of the book Eccentric Orbits: The Iridium Story. “It did what it was supposed to do. It was an engineering miracle. It’s just that not enough people needed a phone at all longitudes and latitudes.”

That’s true only in that not enough people valued the product at the price point. But there are deeper explanations of why this happened. The common explanation is that “cellular spread faster than people imagined.” That wasn’t the root cause.

The root cause of Iridium’s valuation failure was what I call goal seek bias which is a special case of confirmation bias and incentive caused bias. The goal seek function in a spreadsheet allows a modeler to use the desired result of a formula to find the possible input value necessary to achieve that result. To understand how the biases played out in the case of Iridium you must know a few background facts.

Motorola was a satellite subcontractor. It wanted to be a prime contractor, but it did not have a customer. The best way around that problem was to create the customer for Motorola satellites from scratch. Iridium was born for that reason. In order to raise the billions of dollars needed to pay for the system a credible business model was required. Naturally spreadsheets were created and it was necessary to goal seek a total addressable market (TAM) to financially justify building and operating the system to investors. The outcome of that financial modeling was a case of what Warren Buffett calls the institutional imperative at work:  “Any business craving, however foolish, will be quickly supported by detailed rate-of-return and strategic studies.”

The result of the goal seek bias in the case of Iridium was preposterous on its face, if the assumptions were carefully examined.

The phone did not work indoors

The phones did not work in a car

The phones did not work without line of sight to the satellite (buildings and even trees are a problem)

The phones were very big, heavy and expensive

The service was expensive

What did the market researchers ask potential consumers about the Iridium service? A classic leading question of course: “Would you value a mobile phone that you could use anywhere?”  Who wouldn’t say yes to that question? But it wasn’t even close to the right question to ask.

The reality was “anywhere” meant: to use the Iridium service a person would need to find an open field and lug out a heavy and expensive phone and pay expensive rates. That isn’t anywhere. Anywhere means inside buildings and cars or in the shadow of a buildings. On a mountainside is a place but is not enough to mean anywhere and instead is a niche market. My friend and wireless expert Tim Farrar sent this Tweet on the topic:

timf

Goal seek bias ignored this reality and that resulted in a number of silly estimates from forecasters about the size of the mobile satellite market. For example:

satest

The way confirmation bias works inside a company like Motorola meant that the problems with the addressable market I just discussed were rendered invisible and the momentum enabled by social proof (“Hey lots of big companies are behind this”) enabled the system to be built.

“In order to secure bank loans in early 1999, the following subscriber targets (“covenants”) were set for Iridium: 52,000 by March 31, 1999; 213,000 by June 30, 1999 and 454,000 by September 30, 1999. Even though never publicly disclosed, the break-even point for Iridium was expected to be between 500,000 and 600,000. In order to reach this level, Iridium would have had to add roughly 50,000 subscribers per month in 1999. In reality, in March 1999, Iridium only had 10,000 subscribers. The number of three to six million subscribers expected by 2001 was never reached. A comparison between the predicted subscriptions and reality is shown in Figure 12”

compaaa

The end result was both tragic and relatively swift:

On November 1, 1998, after launching a $180MM advertising campaign and an opening ceremony where VP Al Gore made the first phone call using Iridium, the company launched its satellite phone service, charging $3000 for a hand-set and $3 – $8 per minute for calls.  The results were devastating.  By April 1999, the company had only ten thousand subscribers.  Facing negligible revenues and a debt interest of $40MM per month, the company came under tremendous pressure.  In April, two days before Iridium was to announce quarterly results, CEO Staiano quit, citing a disagreement with the board over strategy.  John Richardson, an experienced insider, immediately replaced Staiano as interim CEO, but the die was cast.  In June 1999, Iridium fired 15% of its staff, including several managers who had been involved in designing the company’s marketing strategy.  By August, Iridium’s subscriber base had grown to only 20,000 customers, significantly less than the 52,000 necessary to meet loan covenants.  Two days after defaulting on $1.5 Billion in loans – on Friday, August 13, 1999 – Iridium filed Chapter 11 bankruptcy protection.

Iridium was purchased by an investment group for very little cash and today is both an operating business and a listed company. The business is very different than originally envisioned (r.g., they are chasing non voice markets) and the link to Motorola that would have created huge wholesale transfer pricing problems is gone (Iridium has multiple suppliers). The prospects of that new business is not a subject covered in this post since this is about what happened pre-bankruptcy.

What are “the dozen lessons” in the case of Iridium?

  1. “An unresolved contradiction exists: to perform present value analysis, you must predict the future, yet the future is not reliably predictable.”  “A perfect business in terms of the simplicity of valuation would be an annuity; an annuity generates an annual stream of cash that either remains constant or grows at a steady rate every year. Real businesses, even the best ones, are unfortunately not annuities.” Seth Klarman

When valuing an asset it is wise to focus of the simplest system possible, preferably one that has a stable and well known operating history (e.g., an individual business  like See’s Candies).  Iridium was about as far from an annuity as was possible. When valuing a business like Iridium a massive margin of safety must be built into the model to account for risk (risk meaning the potential for a permanent loss of capital). How are risky investment intelligently made? Well, very carefully. A portfolio approach is used in venture capital since only a very small number of outsize winners determine the financial outcome of a given fund. Warren Buffett describes the strategy adopted:

“If significant risk exists in a single transaction, overall risk should be reduced by making that purchase one of many mutually-independent commitments.  Thus, you may consciously purchase a risky investment – one that indeed has a significant possibility of causing loss or injury – if you believe that your gain, weighted for probabilities, considerably exceeds your loss, comparably weighted, and if you can commit to a number of similar, but unrelated opportunities.  Most venture capitalists employ this strategy.  Should you choose to pursue this course, you should adopt the outlook of the casino that owns a roulette wheel, which will want to see lots of action because it is favored by probabilities, but will refuse to accept a single, huge bet.”

  1. “When future cash flows are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation. Unfortunately, future cash flows are usually uncertain, often highly so. Moreover, the choice of a discount rate can be somewhat arbitrary. These factors together typically make present-value analysis an imprecise and difficult task. Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game. A recurring theme in this book [Margin of Safety] is that the future is not predictable, except within fairly wide boundaries.” Seth Klarman. 

Klarman is pointing out a fact that will be made repeatedly in this post.  A NPV calculation of the value of a business is not precise. This means that having a margin of safety is wise. Everyone makes errors and mistakes and so having insurance against those mistakes is wise.  With a margin of safety you can be somewhat wrong and still make a profit.  And when you are right you will make even more profit than you thought. I have written posts before about the discount rate issue.

  1. “Using precise numbers is, in fact, foolish: working with a range of possibilities is the better approach.” “Charlie and I admit that we feel confident in estimating intrinsic value for only a portion of traded equities and then only when we employ a range of values, rather than some pseudo-precise figure.” Warren Buffett  “Warren talks about these discounted cash flows. I’ve never seen him do one.” Charlie Munger.

Warren Buffett’s response when Charlie said this was to say:  “It’s true. “If the value of a company doesn’t just scream out at you, it’s too close.” “You just want to estimate a company’s cash flows over time, discount them back and buy for less than that.” Warren Buffett “In the Theory of Investment Value, written over 50 years ago, John Burr Williams set forth the equation for value, which we condense here: The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.” Warren Buffett in the Berkshire 2000 annual report.

  1. “In 44 years of Wall Street experience and study I have never seen dependable calculations made about common stock values, or related investment policies, that went beyond simple arithmetic or the most elementary algebra.  Whenever calculus is brought in, or higher algebra, you could take it as a warning signal that the operator was trying to substitute theory for experience.” Ben Graham

Some people are seduced by Greek letters in valuation formulas. Seth Klarman has said: “It is easy to confuse the capability to make precise forecasts with the ability to make accurate ones.”

  1. “DCF is an unruly valuation tool for young companies. This is not because it is a bad theoretical framework; it is because we don’t have accurate inputs. Garbage in, garbage out.”  Bill Gurley

Whenever you receive a spreadsheet valuing a business, it is wise to focus on the assumptions. And as Gurley points out that is particularly true of a young company. But people make emotional mistakes:

“Ed Staiano, formerly a senior executive at Motorola and the CEO of Iridium at the time of commercial activation, knew in intimate detail how the Iridium system actually functioned and was well aware of its various technical limitations, including the fact that the Iridium telephone would not work dependably indoors or in the urban canyons of central business districts, but he made the decision, nonetheless, to invest $500,000 of his own money in Iridium securities in March 1999”

“Multiple witnesses indicated that they were familiar with the “line-of-sight” nature of the system, and, despite that, they appear to have assumed that the service still would be acceptable to users.”

Iridium is a particularly extreme example of garbage in and garbage out. Sometimes people suspend disbelief:

NEW YORK-Iridium World Communications Ltd., which plans to launch a satellite-based global telephone and paging service, went public June 10, raising $240 million in an offering of 12 million shares of Class A common stock at $20 per share. The initial public offering, lead managed by Merrill Lynch & Co., New York, was oversubscribed. Consequently, the issuer, which had planned a 10 million share IPO, increased its initial offering by 2 million shares.

  1. “Buffett’s reluctance to invest in technology businesses “is not a statement that technology stocks are unanalyzable.” Robert Hagstrom in his book The Essential Buffett: Timeless Principles for the New Economy.

Buffett says: “We have no religious belief that we will not invest in tech, just can’t find one where we think we know what the bush will look like in ten years or how many birds will come out of the bush.” Both Munger and Buffett have said that if they were young today they would acquire a technology circle of competence. But they are not young today. What they are looking for is an unfair advantage when they invest and in high-technology they have no such advantage.

  1. “Some of the worst business decisions I’ve seen came with detailed analysis. The higher math was false precision.  They do that in business schools, because they’ve got to do something.” Charlie Munger.

That a spreadsheet generates precise numbers can create an illusion of precision. It is one of several biases that can impact a valuation. Aswath Damodaran:

ad

Multiple bias and illusions were involved in this result:

“The Global Arrangers for a $1 billion credit facility that  closed in December 1997 engaged Coopers & Lybrand (now known as PriceWaterhouseCoopers) and Arthur D. Little to conduct extensive independent diligence with respect to the Iridium business plan as a condition to extending credit to Iridium. These consultants to the lenders “stress tested” the Iridium projections, prepared a more conservative set of projections that assumed a downside case for future company performance after commercial activation and gave a green light to the loan which was oversubscribed.”

  1. “I have seen so many cases where there is a complex model that is exactly wrong.  This focus on a model may cause you to move away from thinking about the competitive advantages of the business. Then you are making decisions based on all these numbers rather than thinking about whether this is one of the ten businesses that you would like to own.” Glenn Greenberg.

Numbers can seduce even the most rational investor. It is qualitative factors that generate quantitative results in a business. Does the business have a sustainable competitive advantage? This can be tested for existence using numbers but it cannot be analyzed by just using numbers. Competitive advantage is determined qualitatively. Mohnish Pabrai make the point in this way: “It’s not about the numbers.  For most investments the factors that will drive long term success don’t have much to do with spreadsheets.  They have to do with something other, either understanding human nature or understanding nuances about how certain aspects of how things work rather than running spreadsheets.”

  1. “So, if one can’t use DCF how should one think about valuation? Well, one solution that I have long favoured is the use of reverse engineered DCFs. Instead of trying to estimate the growth ten years into the future, this method takes the current share price and backs out what is currently implied. The resulting implied growth estimate can then be assessed either by an analyst or by comparing the estimate with an empirical distribution of the growth rates that have been achieved over time, such as the one shown below. This allows one to assess how likely or otherwise the implied growth rate actually is.” James Montier.

Take company X and its market cap. What sort of growth would be required to support that valuation? For Iridium:

May 1998: Full satellite constellation in orbit, stock peaks at $68 7/8 with Iridium’s total market capitalization near $10 billion

Paraphrasing Buffett: “Think about a company with a market cap of $10 billion. To justify paying this price, you would have to earn $1 billion every year until perpetuity, assuming a 10% discount rate. Think about how many businesses today earn $1 billion, or $.75 billion, or $.5 billion. It would require a rather extraordinary change in profitability to justify that price.”

  1. “Some investors swear off the DCF model because of its myriad assumptions.  Yet they readily embrace an approach that packs all of those same assumptions, without any transparency, into a single number: the multiple.  Multiples are not valuation; they represent shorthand for the valuation process. Like most forms of shorthand, multiples come with blind spots and biases that few investors take the time and care to understand.” Michael Mauboussin.

Aswath Damodaran:

“Relative valuation is much more likely to reflect market perceptions and moods than discounted cash flow valuation. This can be an advantage when it is important that the price reflect these perceptions as is the case when

  the objective is to sell a security at that price today (as in the case of an IPO)

  investing on “momentum” based strategies

With relative valuation, there will always be a significant proportion of securities that are under valued and over valued. Since portfolio managers are judged based upon how they perform on a relative basis (to the market and other money managers), relative valuation is more tailored to their needs. Relative valuation generally requires less information than discounted cash flow valuation (especially when multiples are used as screens)”

From January 1998 to January 1999 a great Number of analysts believed that Iridium had an equity value that ranged between $4 and $14 billion. Garbage in and garbage out.

July 1997: DLJ gave Iridium a $6.2 billion private market equity valuation.

October 1997: BancAmerica Robertson Stephens gave Iridium a $9.3 billion private market equity value.

February 1998: Goldman Sachs found $10.6 billion private market equity value.

  1. “Though many DCF models do incorporate sensitivity analysis (typically a grid of values driven by alternative cost of capital, growth, or terminal valuation assumptions), these grids provide little relevant information for anyone trying to understand the prospects of the business. Investors should look to the value drivers—sales, margins, and investment needs—as sources of variant perception. Even sensitivity analysis based on the value drivers is generally flawed because it fails to consider the interactivity between value drivers. Proper scenario analysis considers how changes in sales, costs, and investments lead to varying value driver outcome.” Michael Mauboussin 

Sensitivity analysis is useful in getting a “feel” for a business model. What inputs are most important? Even with a sensitivity analysis since the systems involved are complex and adaptive, scenario analysis is important. Maboussin writes: “Scenario analysis also addresses concerns about an uncertain future. By considering “if, then” scenarios and insisting on a proper discount to expected value—or margin of safety—an investor can safely and thoughtfully weigh various outcomes.

  1. “Generally, when companies or investors run a cash flow model they go out five or ten years. Why is that? Because that’s how many fingers you have. Literally, we live in a decimal world because that is how many fingers we have! What you really want to do is link the competitive position of your business and/or industry to an economically sound competitive advantage period.” Michael Mauboussin 

It is always best to read Mauboussin in the original.

http://www.kellogg.northwestern.edu/faculty/korajczy/htm/mauboussin.valuation.pdf

http://csinvesting.org/wp-content/uploads/2012/06/dangers-of-dcf.pdf

 

Notes:

Iridium: http://fortune.com/2016/10/22/iridium-satellites-airplanes/

Iridium:  https://books.google.com/books?id=4CqvpWwMLVEC&pg=PA1016&lpg=PA1016&dq=iridium+%22business+model%22+cellular+spread&source=bl&ots=LOsJtvtt1o&sig=_0QnbQRf2vXeAbdhemsGSXNonCI&hl=en&sa=X&ved=0ahUKEwjHx-3c0ZXTAhVH32MKHWv8BIIQ6AEIGjAA#v=onepage&q=iridium%20%22business%20model%22%20cellular%20spread&f=false

Iridium: http://www.altfeldinc.com/pdfs/LearnFromTheirMistakes.pdf

Iridium: http://www.tech-go.com/manuals/Iridium.pdf

Aswath Damodaran http://people.stern.nyu.edu/adamodar/pdfiles/execval/relval.pdf  and http://people.stern.nyu.edu/adamodar/pdfiles/country/narrative&numbersshort2017.pdf

Bonus round:

“I agree with Warren to keep it simple and not use higher mathematics in your analysis.” Walter Schloss

“In my life there are not many questions I can’t properly deal with using my $40 adding machine and dog-eared compound interest table.” Charlie Munger

“A person infatuated with measurements, who has his head stuck in the sand of the balance sheet, is not likely to succeed.” Peter Lynch

“Any attempt to value businesses with precision will yield values that are precisely inaccurate.”

“We never sit down, run the numbers out and discount them back to net present value … The decision should be obvious.”  Charlie Munger

“It is better to be approximately right, than precisely wrong.” Warren Buffett

“There’s no such thing as precise intrinsic value.” Mohnish Pabrai

“There are so many factors involved that it is never wise to attempt to judge intrinsic value to the last eighth or even point.” Phil Fisher

“Given that the future is inherently uncertain, we do not believe the value of any business can be known with certainty at a given point in time, so our aim is to be generally right as opposed to precisely wrong.”  Wally Weitz

“It is important to understand that intrinsic value is not an exact figure, but a range that is based on your assumptions” Jean-Marie Eveillard

“Businesses, unlike debt instruments, do not have contractual cash flows. As a result, they cannot be precisely valued as bonds” James Montier

“The essential point is that security analysis does not seek to determine exactly what is the intrinsic value of a given security. It need only establish that the value is adequate.” Ben Graham

“If modest changes in assumptions cause a substantial change in NPV, investors would be prudent to exercise caution in employing this method of valuation.” Seth Klarman

A Dozen Lessons about Business, Investing and Money from Lil Wayne (Weezy)

 

1. “They can’t put no more Weezy baby out. That’s that cash money vasectomy.” From the song: Grateful.

That there was a feud between Lil Wayne and Birdman and another feud with the record label which has distributed Weezy’s music is well known. The core of the issue is “wholesale transfer pricing” (WTP).  Simply put:  WTP is the bargaining power of A that exclusively supplies a unique product X to B which may enable A to take the profits of B by increasing the wholesale price of X.  In this case, the artist (Weezy) is unhappy about by the nature of the revenue split between himself, Cash Money Records and the distributor. The good news is that industry revenue are rising:

The outbreak of streaming has officially helped the music industry rebound after nearly a decade of decline, with the Recording Industry Association of America reporting $7.7 billion in revenue in 2016. That’s the music industry’s highest gross since 2009 and, at an 11 percent improvement over 2015, its best gains percentage-wise since 1998.”

ria rev

2.”The garden’s full of snakes so I had to escape.” From the song: CoCo.

What relative WTP determines is the structure of what is called an industry profit pool,  which is the total amount of profit earned in an industry at all points along the industry’s value chain. The amount of sustainable profit generated by any business is driven by whether it has a moat and the definitive essay on moats was written by Michael Mauboussin. In that essay he writes:

“A profit pool shows how an industry’s value creation is distributed at a particular point in time. The horizontal axis is the percentage of the industry, typically measured as invested capital or sales, and the vertical axis is a measure of economic profitability… Profit pools are particularly effective because they allow you to trace the increases or decreases in the components of the value-added pie. One effective approach is to construct a profit pool for today, five years ago, and ten years ago and then compare the results over time.”

Mauboussin created this profit pool example which illustrates how some firms can be profitable and others not in the same value chain:

app

“the industry as a whole destroyed an average of $19 billion of shareholder capital per year through the 2002-09 business cycle”

The nature of a given profit pool can change over time or not. For example, someone can argue that new developments, like the recent reduction the number of airlines has changed the situation now and profit for airlines may be more sustainable. That is true but that is not relevant to the 2002-09 time period in the chart. One really interesting fact about how the airline industry has changed and how its profitability prospects may have improved is the rising importance of selling airline miles.

Bloomberg reports:

“the sale of miles—mostly to the big banks, but also to companies that range from car rental firms to hotels to magazine peddlers. The latter has expanded so much that it accounts for more than half of all profits for some airlines. [one estimate] is that the margin on this business is 60 percent or 70 percent.”

Profit in a business does not always arrive directly. Weezy knows that. The fact that certain complementary goods exist that can lower factors like CAC and churn can create a really important dynamic when a company adopts something like a freemium/land and expand strategy. For example,

“Credit Karma, a popular credit-monitoring site, wants to do your taxes online for free. [Kenneth Lin’s company is] striking out at TurboTax and H&R Block, which are now charging the typical homeowner or investor more than $90. Credit Karma can offer free tax preparation because it makes money in other ways. The company, with 600 employees, gets paid to recommend financial products, such as credit cards and auto loans, to customers. It says it had revenue of $350 million in 2015 and has been profitable for a couple of years. By breaking into tax prep, Credit Karma hopes to get better data on its members and improve its recommendations. The idea is to create a “trusted digital assistant” for its customers’ financial lives, Lin said.”

As another example, look at the Comcast mobile offering. One of Comcast’s major goals with the wireless service is to reduce churn for the overall bundle of services.“The more products you add, the lower the churn,” said Greg Butz, president of Comcast Mobile.  That lower churn alone can justify the effort. Or not. That depends on the unit economics which we do not know.  Comcast will only sell the mobile service to customers who are already buying its broadband offering (that lowers CAC and COGS; as always everything in lifetime customer value is connected and has reflexivity).

The impact of this freemium/land and expand phenomenon is highly underestimated since it is happening many categories.  The consumer surplus created as these strategies are implemented is massive but so is the producer surplus it eliminates.  The end result is great for consumers but a challenge for businesses that have counted on the revenue to generate profits, not just product promotion. In this way the cost of goods sold (COGS) in many categories is being transformed unto CAC by companies implementing a form of the freemium/land and expand strategy adopted by Credit Karma. In a profile of Bill Gurley I quoted him (in bold) and then wrote:

“If a disruptive competitor can offer a product or service similar to yours for “free,” and if they can make enough money to keep the lights on, then you likely have a problem.” Digital offerings have very strange economics in that multi-sided markets are often involved and offerings in such a market can have close to zero marginal cost once it has been created. Solving the “chicken and egg” problem inherent in any platform business usually involves either a free egg or free chicken on one “side” of the market.  It’s easy to wake up in a digital world and have whatever you were selling now being offered “for free.”

The profit pool in the music industry is not something Weezy is happy about since he believes his share should be bigger. He once said in an interview:  “I want off this label and nothing to do with these people, but unfortunately it ain’t that easy.”

The most important aspect of a profit pool analysis is that it is not just a statement about the top line revenue of a business. Revenue is not profit! It is odd that this even needs to be said, but I am doing so anyway. Too many people think: “Well this business in generating a lot of money!” The assumption is that it must be profitable or is generating the most profit in the value chain, when that is not the case. Music streamers may have a lot of revenue and yet zero profit.  That’s why a profit pool analysis is so interesting.

spot mar

Here’s another example created by Mauboussin:

cpp

Mauboussin’s profit pool graphics illustrate that some sectors of some industries generate huge amounts of value for society and yet no overall profit. This is also true about innovation. Sometimes all of the benefits of an innovation go to consumers. As an example, Bill Gates said once:

“If you look at an industry where you have such a rapid increase in supply, usually that’s pretty bad, like when radial tires were invented, people didn’t start driving their cars a lot more, and so it means the need for production capacity went way down, and things got all messed up.  The tire industry is still messed up. Supply is the killer of value. That’s why the computer industry is such a strange industry.  We’re dealing with amazing increases in supply.”

Sometimes disruption only benefits consumers and producers end up with nothing. Whether something is “disruptive” does not determine whether it may be a direct source of profit for the producer.  This increase in the rate at which producer surplus is transformed into consumer surplus also distorts all sorts of economic statistics like GDP.

3. “If Cash Money Records coming for me, I’m goin’ out like Tony.” From the Sorry 4 the Wait 2 mixtape.

Lil Wayne has considerable leverage in these WTP disputes since, among other things, he is needed to promote the product. He has been able to maintain some leverage for that reason and that so far has produced a stalemate. Lil Wayne’s suggestion that he would rather go out like Tony Montana did the 1983 film Scarface is an often seen negotiation  tactic. In an interview Weezy noted: “Carter V is super-done. Cake baked, icing on top, name on top, candles lit. I would have released it yesterday if I could. But it’s a dead subject right now. It’s a jewel in the safe. It’s that stash-house money.”

4. “Right now, anybody could put out a new song on the Internet and it could become the hottest thing ever. When I was starting, you couldn’t do that type of shit. But that’s wonderful – the game is wide open, and my job is just to stay vital.”

The internet has been a destroyer of many moats that were based on distribution scarcity (for example newspapers and music). People like Weezy have had to increasingly make their profits on concerts and merchandise. I discussed this in my post on Louis CK, Biggie and Rza. Even at Universal mech is a significant revenue line as is streaming:

umerch

5. “I got the key to success, get money invest.” From the song: Over Here Hustlin.

Lil Wayne understands that it is income from services and other work (“get money”) that enables investments. Investments are certainly important, but so is a source of income which is fundamental, especially for younger people.

6. “I’m just chillin, but my money still running ’round.” From the song: Over Here Hustlin.

Lil Wayne is channeling Warren Buffett with this lyric, who once said:If you don’t find a way to make money while you sleep, you will work.” The best way to earn money while you sleep is to invest wisely.

7. “My money so old I tell my new money ‘respect your elders.’”From the song: Living Right.

It is not completely clear what Lil Wayne is talking about in this lyric, but it is possible he is referring to the fact that older assets tend to have a lower tax basis and deserve respect. To lower the tax hit, new assets should be sold first to raise cash for expenses like VIP sessions at clubs or private jets.

8. “I need a Winn-Dixie Grocery bag full of money.” From the song: Got Money. “I gotta posse full of hittas and a pocket full of In God We Trust; It’s been so long since I said “it cost too much.” I’m so addicted to the fast money lifestyle and withdrawal sucks; And dead presidents act immortal, but I know you see money’s not a problem” From the song: “I Feel Good”

People tend to acquire significant hobbies and other habits that require involve significant cash burn rates. Lil Wayne is saying that this can create problems unless you have a lot of cash. For example, as well all know the only unforgivable sin in the VIP section of the club is to run out of cash. Lil Wayne seems know the Warren Buffett admonition well:  “Nothing sedates rationality like large doses of effortless money.” So having a grocery bag full of cash is helpful.

9. “I invest, I stock trade, From Eagle Street, to Wall Street.” From the song:  Hot Boy (Freestyle)

It appears that Lil Wayne is an active stock market investor. He may hold some passive investments in Vanguard and other funds and ETFs but it is not clear from the context of this song lyric. Some people can invest in an active way successfully, but not too many. Charlie Munger believes that ~3% of investors can do so.

10. “Getting mugged from everybody you see.”  From the song: Got Money.

Lil Wayne in this lyric is agreeing with the Charlie Munger idea that jealousy is a worthless emotion. Munger points out: “A member of a species designed through evolutionary process to want often-scarce food is going to be driven strongly toward getting food when it first sees food. And this is going to occur often and tend to create some conflict when the food is seen in the possession of another member of the same species. This is probably the evolutionary origin of the envy/jealousy tendency that lies so deep in human nature. Envy is a really stupid sin because it’s the only one you could never possibly have any fun at. There’s a lot of pain and no fun. Why would you want to get on that trolley?”

11. “Real Gangsta’s die of old age.” From the Song: Cream.

As Hyman Roth said in the movie The Godfather: “Good health is the most important thing. More than success, more than money, more than power.” In keeping with Mr. Roth’s admonition Lil Wayne appears to want to take better care of his health. I need to do that too.

12. “Soon as I learned how to talk I talked business.” From the song: Cream.

In another blog post entitled “A Dozen Things I’ve Learned About the Music Business (and Businesses Like It)” I quote Kurt Cobain as saying: “I wish there had been a music business 101 course I could have taken.” Lil Wayne is saying he learned about business very early in life. That was a good idea. As Warren Buffett likes to say: “I am a better investor because I am a businessman, and a better businessman because I am an investor.”

Notes:

Streaming http://www.rollingstone.com/music/news/music-industry-rebounds-in-2016-thanks-to-streaming-w474394

Airlines https://www.bloomberg.com/news/articles/2017-03-31/airlines-make-more-money-selling-miles-than-seats

Spotify https://www.bloomberg.com/gadfly/articles/2017-04-04/spotify-and-universal-music-strike-right-chord-for-digital-future

MIDiA https://musicindustryblog.wordpress.com/2016/05/25/the-2-spotify-charts-you-need-to-see/

Should Tax Preparation Be Free? Credit Karma Challenges TurboTax – Bloomberg https://www.bloomberg.com/news/articles/2017-04-07/should-tax-preparation-be-free-credit-karma-challenges-turbotax

25IQ Gurley  https://25iq.com/2013/09/09/a-dozen-things-ive-learned-from-bill-gurley-about-investing-and-business/

25IQ Music   https://25iq.com/2016/09/03/a-dozen-things-ive-learned-about-the-music-business-and-businesses-like-it/

Comcast Wireless https://www.bloomberg.com/news/articles/2017-04-06/comcast-enters-wireless-business-with-45-a-month-service

http://www.mtv.com/news/2055325/lil-wayne-sorry-4-the-wait-2-birdman-lines/

http://www.rollingstone.com/music/news/hear-lil-wayne-call-out-cash-money-feud-on-grateful-w438959 and http://www.mtv.com/news/2211964/lil-wayne-birdman-club-liv-drink-thrown/

http://www.rollingstone.com/music/features/lil-wayne-breaks-silence-on-cash-money-lawsuit-free-weezy-album-20150219

 

A Dozen Beliefs About Business, Money and Life that Kanye West Shares With Other Great Entrepreneurs and Investors

1.“For me, first of all, dopeness is what I like the most. Dopeness. People who want to make things as dope as possible, and, by default, make money from it.”

As everyone who is dope knows, “dopeness” is an adjective used to describe the awesomeness of a person, place or a thing. In these sentences Kanye is in effect repeating the Y Combinator motto as stated by Jessica Livingston: “Make something that people want. If you create something and no one uses it, you’re dead. Nothing else you do is going to matter if people don’t like your product.” https://25iq.com/2016/04/09/a-dozen-things-ive-learned-from-jessica-livingston-about-business-and-investing-2/ Kanye understands that the establishing the “value hypothesis” (finding product/market fit) must precede the “growth hypothesis.”

2. “Please avoid trying to talk me out of being me in the future.”

Kayne wouldn’t be interesting if he wasn’t Kanye. In making this statement about “me being me” he is channeling a point made by people like Bill Gurley about the importance of sometimes being a contrarian if you want to outperform a market. Gurley has said in this point: “Being ‘right’ doesn’t lead to superior performance if the consensus forecast is also right.” Andy Rachleff agrees: “What most people don’t realize is if you’re right and consensus you don’t make money. The returns get arbitraged away. The only way as an investor and as an entrepreneur to make outsized returns is by being right and non-consensus.”

3. “One of my biggest Achilles heels has been my ego. And if I, Kanye West, can remove my ego, I think there’s hope for everyone.”

Kayne recognizes in these sentences a point made Howard Marks: “The biggest investing errors come not from factors that are informational or analytical, but from those that are psychological.”  Paul Tudor Jones feels the same way: “Don’t be a hero. Don’t have an ego. Always question yourself and your ability. Don’t ever feel that you are very good. The second you do, you are dead.”  Phil Fisher had a similar view:  “There is a complicating factor that makes the handling of investment mistakes more difficult. This is the ego in each of us.”

4. “If you read books – which I don’t, none at all – about how to become a billionaire, they always say, ‘You learn more from your mistakes.’ So if you learn from your mistakes, then I’m a f*cking genius.”

This statement about the importance of learning from mistakes is straight up Charlie Munger: who has made these same points about mistakes which are quite similar to Kayne’s thesis: (1) “There’s no way that you can live an adequate life without many mistakes.” (2) “Of course, there’s going to be some failure in making the correct decisions. Nobody ‘bats a thousand.’” (3) “I don’t want you to think we have any way of learning or behaving so you won’t make mistakes.” Munger is a self-described “book with legs sticking out” and reads constantly.  But he would never read a book about how to become a billionaire. 

5. “Having money isn’t everything, not having it is.” 

In my blog post abut what you can learn from comedians I pointed out that Johnny Carson once said: “The only thing money gives you, is the freedom of not worrying about money.” Kayne seems to understand why Seth Klarman said: “The trick of successful investors is to sell when they want to, not when they have to.” People who don’t have cash can be forced to sell other assets when they do not want to. Cash is always valuable, but there are times in the business cycle when cash is particularly valuable and planning ahead for those times is wise.

6. “I just have to look at say, ‘What do I have to lose? We only have everything to gain.’”

Kayne is thinking like Nassim Taleb on the value of convexity: “Optionality is the property of asymmetric upside (preferably unlimited) with correspondingly limited downside (preferably tiny).”  Sam Zell said something very similar in a New Yorker profile: “Listen, business is easy. If you’ve got a low downside and a big upside, you go do it. If you’ve got a big downside and a small upside, you run away. The only time you have any work to do is when you have a big downside and a big upside.” This statement from Kanye is all about the value of seeking positive optionality. Every once in a while, if you are looking hard for opportunities, you will find a mis-priced bet within your circle of competence with a relatively capped downside and a huge potential upside. 

7. “Visiting my mind is like visiting the Hermès factory. Sh*t is real.” 

Kanye appears to be comparing himself to certain hedge fund founders in terms of his self-appraisal of his own IQ.  Many hedge fund greats are unabashed fans of their own mental competence like Kanye. John Bogle pointed out the dangers of overestimating one’s own IQ when he said: “We all think we’re above average investors just like we all think we’re above average dressers, I suppose, above average intelligence. Probably we all think we’re above average lovers for all I know.”

8. “I am so credible and so influential and so relevant that I will change things.”

Kanye is channeling George Soros on reflexivity.  Soros believes: “Markets can influence the events that they anticipate. Markets and the views of people about markets interact dynamically in their effect on each other. There is a two-way reflexive connection between perception and reality which can give rise to initially self-reinforcing but eventually self-defeating boom-bust processes, or bubbles. Every bubble consists of a trend and a misconception that interact in a reflexive manner.” Kanye understands that people almost never make decisions independently. Duncan Watts writes: 

“when people tend to like what other people like, differences in popularity are subject to what is called “cumulative advantage,” or the “rich get richer” effect. This means that if one object {like Kanye] happens to be slightly more popular than another at just the right point, it will tend to become more popular still. As a result, even tiny, random fluctuations can blow up, generating potentially enormous long-run differences among even indistinguishable competitors — a phenomenon that is similar in some ways to the famous “butterfly effect” from chaos theory….n such a world, in fact, the question “Why did X succeed?” may not have any better answer than the one given by the publisher of Lynne Truss’s surprise best seller, “Eats, Shoots & Leaves,” who, when asked to explain its success, replied that “it sold well because lots of people bought it.””

9. “I’ve gotta get my money up to another level cause it ain’t on Jay Z level, it ain’t on Diddy level yet. I’m talking about economic empowerment because the economics give you choices, the choices can help give you joy and freedom. And I’m trying to find that joy.”

Kayne seems to be talking about issues that Bruce Berkowitz identifies in this quote: “Cash is the equivalent of financial Valium. It keeps you cool, calm and collected.” In my blog post on what you can learn from comedians I note that Chris Rock once said: “Wealth is not about having a lot of money; it’s about having a lot of options.”

fur

10. “I think business has to be stupider. I want to do really straightforward, stupid business — just talk to me like a 4-year-old.”

Kanye is advocating the same game plan Warren Buffett does here:We try to stick with businesses we believe we understand. That means they must be relatively simple and stable in character. If a business is complex or subject to constant change we’re not smart enough to predict future cash flows.”  Risk comes from not knowing what you are doing and keeping it simple lowers risk for that reason.Business is hard. Vanity Fair notes about Kanye’s business efforts so far:  

“In 2009, he put all of his musical endeavors aside to work on his label, Pastelle—which then shuttered after seven months. Add to that however much it cost to create his line of G.O.O.D. merchandise, marketed to fans of his record label. He was chewed up and spit out for his attempt at a high-end women’s-wear line called Kanye West in 2011. The line never made it to stores.”

Good judgement comes from experience and a lot of that come from bad judgement said Will Rodgers and hopefully Kayne is learning from his troubles as well all should.

11. “One of my courses was piano. I actually went to college to learn how to play piano. Talk about wastin’ some money.”

Kanye is expressing concern about the value of some aspects of college that he shares with Peter Thiel who has said: “I’ve never claimed that nobody should go to college or that we should shut down all the universities in this country or anything like that. What I have argued is that there is no one-size-fits-all, and that we need to have a more diverse array of things that people, including our most talented people, can be doing.” Learning should not start or stop with college.

 12. “My definition of success is dropping a Charlie Sheen-level tweet and being like, ‘I am in debt and f— you.’” “Also for anyone that has money they know the first rule is to use other people’s money.”

Kayne has probably not thought a lot about the ideas of Mike Milken. But Milken did once say something that Kanye should know:  “Debt isn’t good. Debt isn’t bad. For some companies, close to zero debt is too much leverage. For other companies, nearly 100 percent much higher levels of debt can easily be absorbed.” The same idea applies to people. As Charlie Munger has said: “I’ve seen more people fail because of liquor and leverage – leverage being borrowed money.” Montier adds: “Leverage can’t ever turn a bad investment good, but it can turn a good investment bad.  When you are leveraged you can run into volatility that impairs your ability to stay in an investment which can result in “a permanent loss of capital.”

P.s., Kanye is Kanye, and I am not. Why is Tren writing about people like Kanye? First, I think you can learn something from everyone. Second, it is hard to get people to read anything about finance.  Adding someone like Kayne to the mix increase the number of people who will read the post. I can see it in the data. Why do I care about page views if I have no advertising or other business model?  As you may know I am fond of quoting Charlie Munger who once said: “The best thing a human being can do is to help another human being know more.” If people don’t read they can’t learn.

You may ask: “Why can’t Tren just write in a ‘seven simple rules for success’ format?  Unfortunately the world does not work that way.  A step-by-step formula for achieving wealth and happiness does not exist. Over the course of over 215 blog posts I have been advocating that readers adopt the “worldly wisdom” approach of  Charlie Munger which is based on the concept of a “lattice of mental models.” Your task, if you decide to adopt this approach, is to combine a range of mental models into a lattice and acquire “worldly wisdom.” A premise of the worldly wisdom approach is that there is no precise recipe for success. Munger instead suggests that individuals combine attributes like patience, rationality, cultivating optionality and aggressive opportunism. While the combination of attributes like patience and pouncing on opportunities may seem a bit strange at first, it is an approach that can lead to a highly favorable outcome. Munger says: “You’ve got to array your experience ‑ both vicarious and direct ‑ on this latticework of models. You may have noticed students who just try to remember and pound back what is remembered. Well, they fail in school and in life.” By reading about the approaches of others and their successes and failures, you can begin to spot patterns that can help you make decisions in life. For example, you can do things like learn not to pee on an electric fence without doing it yourself. Be careful out there.

 Notes: 

Duncan Watts:  http://www.nytimes.com/2007/04/15/magazine/15wwlnidealab.t.html?_r=1&ref=magazine&pagewanted=all&oref=slogin

 

Core Product Value and Entrepreneurial Success

 

I have previously written about Minimum Viable Product (MVP) and Product/Market Fit (PMF). These are important processes based on the scientific method that can be used to test a value hypothesis. That hypothesis does not just appear via spontaneous generation. Andy Rachleff describes what should be included in a value hypothesis as: “the features you need to build, the audience that’s likely to care, and the business model required to entice a customer to buy your product.”

At the center of any value hypothesis is “core product value” and the idea or vision behind that CPV is created by the entrepreneur.

As an example of how this process works and fits into a bigger picture, Chamath Palihapitiya’s approach has been depicted below by one of his colleagues:

top funnel

Core product value represents a solution a real problem that is valuable enough to cause people to want to pay for a product. Core product value is first recognized when the customer connects with the product in an A-Ha moment.

Core product value is an essential element of product/market fit which is a broader concept that requires additional elements. Andy Johns says: “For products that get the ‘magic moment’ and ‘core product value’ right, the top of the funnel naturally and rapidly fills.” in other words, without core product value and a magic moment it is not likely that people will convert from guests to customers. In a talk at Index Ventures Andy Johns talked about an example of what he feels is core product value:

“One current company with a clear core product value, Johns says, is Snapchat. Their core value isn’t just sexting as some like to believe; rather, it’s the removal of a designated target and mental friction from messaging. Users receiving snaps don’t have to worry about who else may be seeing a message or what their response is, and by removing that moment of hesitation, a social burden is lifted.”

You can disagree with his conclusion but I think even then you will understand his point. As another example, Johns believes that for Wealthfront, where he works now, core product value is giving any customer access to low-cost, tax-efficient, diversified investment portfolios via a direct to consumer model.

Finding a new source of core product value is: (1) very hard to do and (2) a rare event. As context, there are roughly 5,000 seed stage startups a year and only 800 of them raised a Series A round in 2016 reported Mattermark. Why do so many startups fail to successfully raise an A round? There are many reasons for this but most often it is because there is insufficient confidence among investors that the business has found or will find core product value or product/market fit. Andy Johns points out that among the right questions to ask when thinking about whether something has core product value are: Is the problem your product is solving (1) painful, (2) important for your customers, and (3) is there a sizable market behind this problem?  He adds that: “some firms create new, meaningful experiences, rather than solving an existing, painful problem. One could count Facebook, Twitter, Snapchat, Instagram, and others in this group.”

Fred Wilson describes the steps on a startup’s journey:

“The first step you need to climb is building a product, getting it into the market, and finding product market fit. I think that’s what seed financing should be used for.

The second step you need to climb is to hire a small team that can help you operate and grow the business you have now birthed by virtue of finding product market fit. That is what Series A money is for.

The third step you need to climb is to scale that team and ramp revenues and take the market. That is what Series B money is for.

The fourth step you need to climb is to get to profitability so that your cash flow after all expenses can sustain and grow the business. That is what Series C is for.

The fifth step is generating liquidity for you, your team, and your investors. That is what the IPO or the Secondary is for.”

Fred seems to be saying that he wants his portfolio companies to have product/market fit before the Series A which means they will also have discovered core product value as part of that process. It is worth pointing out that what constitutes product/market fit is always to a degree in the eye of the beholder, is not a discrete event and can disappear (e.g., a competing product emerges) and reappear like a Cheshire cat. I did a quick survey of a few VCs to get a current sense of what the standards are on product/market fit at a Series A financing. One venture capitalist I talked to said that only 5% of Series A rounds involve a company that does not have product/market fit. Another said that the percentage ranged from 10 to 40% depending on the firm and that it varies by partner. He also said that Series A rounds that do not have product/market fit “tend to skew smaller ($3-5M) and the firm tends to lead taking the whole round.” Another VC mentioned that there has been some easy grading on whether product/market fit exists and so that impacted her estimate of 20%. Another VC said: “15-20% are non-PMF A rounds, but they seem to be exceptional either by virtue of all-star founding team or a particularly hot area.” Another VC joked that that 30% of A rounds funded by VCs did not have product/market fit intentionally and another 29% failed to achieve this unintentionally. Raising funds after the seed round without proven core product value and product/market fit or can happen for many reasons including because the venture backers: (1) confuse progress on the growth hypothesis with a solution to the value hypothesis (product/market fit); (2) hope that product/market fit can still be discovered with more cash or (3) various errors in judgment caused by a really great story told by a really great story teller. The startup landscape is littered with the invisible dead bodies of failed startups.

The VCs I talked to generally said that a Series A without product/market fit was more likely if there is a huge potential market, a great story is being told and the specific venture capitalist involved is a “people person” on a relative basis.Having said that, Josh Kopelman’s advice on this issue is excellent: “Keeping your burn rate low until you have product/market fit will give you the best chance at building a big company. There’s nothing that increases your odds of a successful A round like a successful launch followed by customers that really love what you’ve built. These inflection points change year to year — so be sure you know what’s currently fundable.” Someone like Elon Musk may be able to raise an A round without core product value and product/market fit, but you are not Elon Musk, and neither am I.

As an aside, as Mark Suster and others have said:

“what actually IS the definition of a seed vs. A-round.

‘Cautionary note: No competent VC is actually fooled when you show up after raising $6M in seed financing and say you’re now raising an A!’

— Marc Andreessen (@pmarca) October 7, 2014

This is something I think entrepreneurs don’t totally understand and it’s worthwhile they do. My view: “Spending any time or energy trying to game the ‘definition’ of your round of fund raising is a total waste. Nobody cares. No VC will be so naive as not to see straight through it. And actually many will probably find the gamesmanship as a bad sign of lack of property priorities or perspective.”… If it looks like an A-round, smells like an A-round & tastes like an A-round … it’s an A-round…. if you raised $3–5 million from well-known seed funds or from a VC and you’re asking for $8–10 million in your next round … that next round is a B-round no matter what we collectively decide to call it when we VCs fund you.”

It is possible for a startup which has not proven that they have core product value and product/market fit raise a Series B? Sure. But is it likely? No. is is significantly less likely that in an A round.  Significantly fewer firms raise a Series B than a Series A. Sreies B is often called the hardest round to raise. Fred Destin writes: “Series B is hard for a simple reason: suspension of disbelief fades and is replaced by an increasingly cold, hard look at milestones and progress. Series B is the round where the rubber meets the road, where the promise has to be met with numbers and projections.”

fr

Andy Chen has written about TTPMF – the “Time to Product/Market Fit.” Remembering that you must have core product value to get to product/market fit his view is:

“TTPMF has to be less than 1-2 years or else your startup will implode. Ask anyone who’s been working on a product for more than 2 years and doesn’t have traction to show: It really, really sucks. The first 6 months can be fun because it feels like you’re painting on a blank canvas, but soon enough, there’s just fatigue and the window of opportunity shifts. Platforms change, investors get disengaged, your employees start getting excited about other companies. So if you miss your window, then you’ll run out of money or energy or both.”

Chamath Palihapitiya has a gift for getting to the point.  You can’t make the most important point about core product value in a simpler way than this slide:

ah-ham

 

Steve Blank believes: “The best entrepreneurs are the ones who are passionate about solving a problem because they’ve had it or seen others have it, love those customers, love solving that problem or have been domain experts. Those are authentic entrepreneurs.” He believes “entrepreneurs, at their heart, are artists. … What comes out from the great artists is something completely unexpected. World class entrepreneurs understand something that is driven by passion.” He believes world class entrepreneurs are connected to their subject and with their customers.’ Blank believes entrepreneurship is a calling rather than a job.  I believe that this is why many venture capitalists describe what they do as “artisanal.” Blank believes:

“Founders fit the definition of a composer: they see something no one else does. And to help them create it from nothing, they surround themselves with world-class performers. This concept of creating something that few others see – and the reality distortion field necessary to recruit the team to build it – is at the heart of what startup founders do. It is a very different skill than science, engineering, or management. Entrepreneurial employees are the talented performers who hear the siren song of a founder’s vision. Joining a startup while it is still searching for a business model, they too see the promise of what can be and join the founder to bring the vision to life.”

The great entrepreneurs tend to be persistent, obsessive and relentless, but the really great entrepreneurs also seem to have a gift for looking at the world from a customer’s viewpoint. These entrepreneurs seem to know instinctively what the customer wants. Most artistic entrepreneur I have ever seen is Craig McCaw. He has an amazing way of putting himself in the shoes of the customer. Rich Barton is very similar in his ability to know whether (1) the customer’s problem is real and significant enough that they will pay for the solution, the market is big, and that there is a business model with a potential moat. Steve Jobs had an artist’s skills in understanding what customers wanted. Bill Gates, Jim Sinegal and Howard Schultz all fall in the artist category. The people are also missionaries rather than mercenaries.  Missionaries are far less inclined to sell the business and more inclined to build a franchise that is truly lasting. Do all founders who are missionaries, visionary, persistent, obsessive and relentless succeed?  No. But they succeed more often. I talk about this is my blog post on the wonderful Michael Mauboussin book The Success Equation. Mauboussin wrote: “The trouble is that the performance of a company always depends on both skill and luck, which means that a given strategy will succeed only part of the time. So attributing success to any strategy may be wrong simply because you’re sampling only the winners. The more important question is: How many of the companies that tried that strategy actually succeeded?” Once up a time long ago I read a book called In Search of Excellence. The authors analyzed leading companies are sorted out the secrets of success in a way that suggested that it was a formula that could be replicated easily. The best companies do X, Y and Z was the claim. What was missing of course were all the companies that did X, Y and Z and failed. Mauboussin writes:

“There are numerous books that purport to guide management toward success. Most of the research in these books follows a common method: find successful businesses, identify the common practices of those businesses, and recommend that the manager imitate them. Perhaps the best known book of this genre is Good to Great by Jim Collins. He analyzed thousands of companies and selected 11 that experienced an improvement from good to great results. He then identified the common attributes that he believed caused those companies to improve and recommended that other companies embrace those attributes. Among the traits were leadership, people, focus, and discipline. While Collins certainly has good intentions, the trouble is that causality is not clear in these examples. Because performance always depends on both skill and luck, a given strategy will succeed only part of the time.Jerker Denrell, a professor of behavioral science, discusses two crucial ideas for anyone who is serious about assessing strategy. The first is the undersampling of failure. By sampling only past winners, studies of business success fail to answer a critical question: How many of the companies that adopted a particular strategy actually succeeded?”

The best venture capitalists want to be involved in enabling entrepreneurs to be successful in this artistic process. You will sometimes hear people say “providing venture capital is just finance. You go to school and listen to a bunch of case studies and learn the formula.” That’s bullshit. I don’t know anyone with any significant degree of success in venture capital who thinks that way. The more the venture capitalist understands that finding core product value is an art and what they do is provide a service that goes beyond finance, the better their financial result.  The best venture capitalists spend a lot of time listening, let the founders do the heavy lifting and do not try to supply the vision (“You do not want a venture capitalist who hires a dog and then tries to do the barking”). Marc Andreessen says: “You want to have as much ‘prepared mind’ as you possibly can. And learn as much as you can about as many things, as much as you can. You want to enter as close as you can to a zen-like blank slate of perfect humility at the beginning of the meeting saying ‘teach me’…. We try really hard to be educated by the best entrepreneurs.”

Some of the best venture capitalists are people who ask great questions that help the entrepreneur find core product value and get to product market fit. Bruce Dunlevie is a great example of someone who has a service mentality in his work as a venture capitalist. Many entrepreneurs trust him implicitly since they know he asks great questions and has sound judgement. Here’s a story told by Jeff Hawkins about that skill:

“Hawkins: Yes, Palm was struggling. We had 27 employees, we had a couple of million dollars left in the bank. All of our partners had abandoned us on doing Zoomer 2. No one was interested in doing PDAs at all, and there was no real business selling PalmConnect and Graffiti. We were kind of bummed out, everyone was sort of miserable about it. But I still believed in the mobile computing space. So Donna Dubinsky and I went and visited one of our VCs one time, Bruce Dunlevie. We were sitting in his office and we were complaining about how our partners had abandoned us and how everything was hard, and Bruce said– my recollection was in an annoying tone, “Well, I don’t want to hear you complain about this. Do you know what you should be doing?” Something along those lines. And I said, “Yes, I know what we should be doing,” although I had no idea what we should be doing. But I said, “I can think of it”– immediately I said I can think of what we should do. If you ask me, I’ll tell you what we should do, something different. It occurred to me right away. I said, “Well we should do a new computer and we’re going to take everything we’ve learned and fix all the problems and do it again. That’s what we should do.” I didn’t know what that would look like yet because we had never really considered doing the whole computer again ourselves. We were still trying to work with Casio and GeoWorks and other people. And Bruce said, “Well if you know what to do, why don’t you go do it?” And our answer was, “We don’t really have the money to do that, we don’t really have the right type of people to do that– we only have software people. But if you think we can, if you don’t mind us trying, we’ll go do it.” And that was the beginning, the genesis of the Pilot. That night I went home and– I’m not sure, I think it was that night, maybe it was the next night, I don’t remember, I think it was that night.”

Here is an example of what WeWork’s Adam Neumann says about Dunlevie’s contribution:

“One example of this is Benchmark Capital, one of our investors. It’s a very successful VC firm, that works with companies like Uber, Snapchat, and Instagram. The partner that brought me in, Bruce Dunlevie, one of the original founders, is one of the smartest people I’ve ever met. Immediately after I met him, he became one of my five to seven close “advisors” that I asked a lot of both business and personal questions.”

There are many other successful entrepreneurs who tell the same story about Bruce. Someone I know said once: “Most stories about Bruce revolve around him being the world’ greatest person who is the best advisor anyone could ever hope for.” Those are qualities that an entrepreneur should seek in a venture capitalist. Dunlevie said to me once: “pattern recognition is an essential skill in venture capital.” While the elements of success in the venture business do not repeat themselves precisely, they often rhyme. In evaluating companies, the successful venture capitalist will often see something that reminds them of patterns they have seen before. It might be the style, chemistry or composition of the team or the nature of the business plan. Some things will be fundamentally different but other things may be familiar. While the pattern will be similar, something in what the team is doing will seem to break a rule. Part of the pattern that is being recognized is a rule breaking innovation of some kind which drives new value.

Creating “core product value” by finding a value hypothesis that is capable of being the foundation of a valuable business is a process similar to alchemy says Benchmark Capital’s Peter Fenton:

“Doing this job for almost 20 years now has taught me far more about people than about business. So let me first answer what I’ve learned about business, and in this case I mean the business of investing in startups. I started out as someone who had all the conceptual overhead needed to sound intelligent in our world, Porter’s 5 Forces, the Innovators Dilemma, and Crossing the Chasm. I would, in my former firm’s parlance, develop a “prepared mind” in a sector so I could see where the logical opportunities should exist. I became an expert on Storage, on Application Software, on Supply Chain. All of that, I came to realize, was useless without the alchemy of an entrepreneur who was playing around with explosive market forces. Yes we can look, and it helps to look with a lens, but the best ideas and companies aren’t filling logical white spaces. They are touching nuclear reactor of some force that will yield, and yield quickly, to an entrepreneurial leader.”

“I also came to realize that at the beginning, no analysis can capture ‘what can go right’ without sounding like you are clinically insane. Having seen the Series A pitch for Facebook, Uber, Snap, Twitter, Vmware…$1B in revenue for any of those companies would have been nearly impossible to imagine. Yet in each of those cases, I vividly remember the meetings, the day, the setting…and this feeling that an exceptional entrepreneur had touched on something nobody else had understood at their level of depth and insight. Each in its own way felt limitless. I’ll never forget meeting Evan Spiegel in 2012 at Sightglass in SF and leaving thinking, I know with all of my being that this person, this product, will give humanity back the playful joy of self-expression, which had been stolen away by then current social networks. Sometimes it’s obvious.”

What else helps someone find core product value? Domain expertise, beginner’s mind, and a personal desire to solve a problem that has caused the entrepreneur genuine personal pain. Jim Goetz of Sequoia believes:

“Many of the entrepreneurs that we back are attacking a personal pain.” “The common thread [between Sandy Lerner and Len Bosack (the founders of Cisco), Reid Hoffman (LinkedIn) and Omar Hamoui (AdMob)] is that these were all sketchy misfits, unknowns, who all focused on [solving] personal pain points and were all willing to put something out early and iterate.”

The best case happens for the venture capitalist when someone has the savant qualities I described when it comes to products and is attacking a personal pain that the care about is a missionary fashion. Michael Moritz of Sequoia not surprisingly has the same views as Goetz: “When we help organize one of these companies at the beginning, it never looks like the world’s greatest idea. I think it’s the marketing and PR department that rewrites history and tells you that it was always the world’s greatest idea. What they don’t say is that at the very beginning there was great uncertainty and a great lack of clarity.” “We just love people who perhaps to others look unbackable. That has always been our leitmotif of doing business.” “If you have been around the start of success it is far easier to recognize it again.”

Steve Blank said this during a GigaOm video interview: “I did this at SXSW. I said ‘There are 500 people in this room. The good news is, in ten years, there’s two of you who are going to make $100 million. The rest of you, you might as well have been working at Wal-Mart for how much you’re going to make.’ And everybody laughs. And I said, ‘No, no, that’s not the joke. The joke is all of you are looking at the other guys feeling sorry for those poor son-of-a-bitches.’” Financial success in creating and funding startups follows a power law.  This means that a very small number of startup founders, employees and investors will reap most all of the financial rewards.  The overconfidence heuristic will make most everyone overconfident that the winners will include them. The inevitable failures are hard for individuals, but the right thing for society as a whole.

One thing is clear: if an entrepreneur wants to discover core product value they should find a venture capitalist who knows that journey well, has a service mentality, asks great questions and has sound judgment.

Notes:

Chamath Slide Deck: https://www.slideshare.net/growthhackersconference/how-we-put-facebook-on-the-path-to-1-billion-users

Fenton in Quora: https://www.quora.com/What-has-being-a-venture-capitalist-taught-you-about-people-and-business

Andy Johns: http://linkis.com/firstround.com/revie/VuHlS  http://www.greylock.com/building-growth-model-company/

Index Ventures: https://www.indexventures.com/news-room/index-insight/growth-101-wealthfront%E2%80%99s-andy-johns-on-how-to-build-and-test-a-sustainable

Alex Schultz: https://www.youtube.com/watch?v=n_yHZ_vKjno

Bruce Dunlevie story re Palm:  http://archive.computerhistory.org/resources/text/Oral_History/Hawkins_Jeff/Hawkins_Jeff_1.oral_history.2007.102658113.pdf

Bruce Dunlevie interview: https://books.google.com/books?id=FCMbUYFSZVQC&pg=PT297&lpg=PT297&dq=%22what+we+do+has+nothing+going+for+it+at+the+time+we+look+at+it%22+Bruce&source=bl&ots=FrkZgK8a-h&sig=_QzYXUyWiAeN3wDRNT1sgX9HUGE&hl=en&sa=X&ved=0ahUKEwiI7YPF_-nSAhXhr1QKHVCdBTUQ6AEIGjAA#v=onepage&q=%22what%20we%20do%20has%20nothing%20going%20for%20it%20at%20the%20time%20we%20look%20at%20it%22%20Bruce&f=false

Fred Wilson:  http://avc.com/2014/06/what-seed-financing-is-for/

Steve Blank: https://steveblank.com/2011/05/27/entrepreneurs-as-artists/   https://www.youtube.com/watch?v=BhD9CXAsVAI and https://steveblank.com/2011/03/31/entrepreneurship-is-an-art-not-a-job/

Andy Chen: http://andrewchen.co/ttpmf-time-to-product-market-fit/

Adam Neumann: https://www.fastcompany.com/3041812/why-im-glad-i-never-had-a-mentor

Mark Suster:  https://bothsidesofthetable.com/what-is-the-definition-of-a-seed-round-or-an-a-round-2cf20264297c#.1lsy4fxl4

Josh Kopelman: http://firstround.com/review/what-the-seed-funding-boom-means-for-raising-a-series-a/